Valuations Didn't Cause the Rout, But They Could Keep It Around

  • Nowhere to hide in a market that marched higher for years
  • Harmonized valuations are in some ways worse than in 2000
Sonders Says Playing Field Leveled for Active Vs. Passive Investing

It’s the same thing every day. You roll out of bed, check the markets, and instead of seeing the mousy little moves that prevailed in stocks the last three years, some index is lurching by 1 percent or more.

And while everyone is by now aware of the big forces buffeting stocks -- bond yields, inflation, the end of easy money -- there’s a lot within the market itself that set the stage for this type of reaction.

One is valuation. Not just the elevated state of megacap tech companies -- the elevated state of everything.

To see just how hard it is to find shelter, Leuthold Group divided U.S. equities into 10 groups by median market capitalization. It found that not only is the whole market trading at valuations exceeding the long-term average, it’s arguably worse than in February 2000, just days before the Nasdaq Composite Index made its bubble-era high.

At about 23 times earnings, the multiple in the biggest market-cap decile now is basically identical to then. Move a few steps down in size to the slot representing mid caps, and the gap between yesterday and today gets bigger: a P/E of 26 times now, versus 15 in 2000. The smallest stocks fetched 10 times annual profit back then, versus 20 now.

“Everyone had crowded into tech and telecom sectors in 2000, but the prices you paid for at least some companies were still quite attractive,” said Doug Ramsey, chief investment officer at Leuthold. “Today, the market is very expensive across the capitalization spectrum, there is literally nowhere to hide. We are seeing a much broader degree of overvaluation.”

Despite epic overvaluation in swaths of the market in February 2000, about 90 percent of the U.S. capitalization spectrum traded at or below their average multiples from 1983 to 2000, research by Leuthold showed. In contrast, the median P/E ratio for some groups is now almost double the levels recorded in February 2000.

A note by Wolfe Research echoes Leuthold Group’s valuation concerns. Stocks are rapidly approaching levels in the late 1990s when measured against earnings before interest, taxes, depreciation and amortization, or versus enterprise value, according to a study published Tuesday. Even though the selloff in the past two weeks improved the picture, rich multiples still pose “considerable” downside pressure for the global equity market, the note said.

A nearly 10 percent rout in the S&P 500 lowered the S&P 500’s forward price-earnings ratio to as low as 16.6, down from 18.7 in late January. That’s still about 7 percent higher than the 10-year average, data compiled by Bloomberg show.

“Valuations are still high by most measures relative to any type of long-term averages,” said Jason Browne, chief investment officer at FundX Investment Group. “They’re less high obviously than prior to the pullback, but they are still pretty high.”

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