The good news is that although the US equity market has experienced a recent re-rating driven by the performance of the Magnificent 7 tech stocks (most notably Nvidia) we show in Exhibit 1 below that the latest 12M PE ratio remains about 16% below the 2021 peak valuation of 24.5x.
Exhibit 1: The current US PE is quite a long way below the 2021 peak valuation.
However, there are mixed signals generated by other valuation methodologies.
In Exhibit 2 below we show time series of the Buffet Indicator (Market Cap v GDP), the Cyclically Adjusted PE (CAPE) and the 12M forward PE ratio going back to 1970.
While the Buffet Indicator is well above the levels seen at the peak of the Technology, Media and Telecoms (TMT) bubble at the end of the 1990’s both the CAPE and 12M forward remain well below the late 90’s level. However, both valuations now sit well above their respective long run average levels implying some mean reversion risk.
Exhibit 2: Comparing the Buffet, CAPE and 12M valuation status back to 1970
The CAPE is not a good market timing tool - instead it should be seen as a component of long-term return forecasting.
The expansion in the CAPE valuation over the last few years has often been cited as justification for a market correction. The lesson from this is that it displays little utility as a tactical market timing tool. We show in Exhibit 3 that the CAPE valuation metric should instead be used as part of the long-term return forecasting process. The premise being that if you start from a high valuation base the subsequent returns will be lower ( and vice versa).
We show the regression between the CAPE valuation and subsequent 10-year returns and show that the current CAPE valuation points to low single digit returns.
Exhibit 3: Regional consensus EPS growth rate forecasts
Source: Wilshire Indexes, FactSet and LSEG Datastream. Data as of February 19, 2024
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