Santoli: Nearly everyone knows US stocks aren’t cheap, but it may not matter

Published Sun, Mar 5 20176:48 PM EST

The market is a constant argument over the right price to place on an unknowable future. Yet nearly all market players agree on one thing: U.S. stocks aren't cheap. The disagreement surrounds just how expensive they are, whether it's justified and whether valuation "matters" for now. There are many ways to portray how equities are valued versus companies' profits and their future cash flows. Among the most conservative – some would say punitive – methods, is Robert Shiller's Cyclically Adjusted Price/Earnings ratio, based on the past 10 years' reported earnings for the S & P 500. That ratio is above 29, a level only exceeded in the past century during the late-'90s bubble years. (Of course, this measure has looked "too high" for much of the past decade, as the market has continued marching higher.) Then there's the "trailing" and "forward" P/E. Based on last year's operating profits, the S & P is just above a 19 multiple; on the consensus forecast for 2017 results, a bit over 18. Whatever gauge is used, stocks are more expensive than they've been at any point of this economic cycle and since the last major bear market ended -eight years ago this Wednesday. The immutable math of investing says the richer valuation you pay, the lower your expected long-term returns. So why are investors willing to pay up for stocks at relatively stout valuations, in the form of heavy equity-fund inflows, during this impressively persistent phase of the rally? Fundamental Tailwind A global economic acceleration and revival of corporate sales and earnings are a decent tailwind to the "denominator" of the market's P/E ratio. S & P 500 operating profits have been essentially flat near $120 for the past three calendar years. The current collective 2017 forecast is for $131, which is where that 18 multiple on the index's current 2383 level comes from. The idea that energy-sector profits are going from negative to positive and industrial earnings are rising from a deep recession-like downturn should at least support stocks' valuation for a while. Stocks were only slightly less rich in mid-2015 just ahead of a steep earnings downturn, so if we're in a phase of recovering profits that effectively lengthens the entire cycle, investors can stomach current multiples. The issue, of course, is that 12-month forecasts are almost always revised down through the course of a year. Strategas Research says the consensus implies 6 percent revenue growth and peak profit margins. The pace of reduction this year has so far been less steep than average, but if the typical earnings-erosion path is followed, then 2017 would land near $123, making today's P/E 19.4. It's fair to bet that late this year or into 2018, tax cuts, federal stimulus and/or deregulation could add to the corporate bottom line. And it doesn't seem that such effects are yet baked into Street estimates. Still, policy seems more of a help to stocks as a handy narrative that gets investors comfortable with the market at today's levels, than a rigorous forecast of fundamental drivers. Valuations Are Tomorrow's Worry In the moment, perhaps investors don't particularly care about valuation, or they understand that valuation doesn't particularly matter for market direction for long stretches of time. Stocks are going up, optimism on the economy and expectations for possible policy help are high. Major bull markets tend ultimately to get to or above a 20 P/E ratio eventually. Still-low inflation and interest rates give investors the psychological cover and ready excuse to pay more for stocks, too. When the prevailing yield on junk bonds is near 5.6 percent, as now – around the lowest in history – it would be odd, as a practical matter, if equity valuations weren't pulled higher as well. Yes, low rates and inflation help explain higher valuations, but they don't "justify" them, in the sense of supporting higher future returns from expensive stocks. Low rates are the world's way of saying "Financial-asset returns are likely to be mediocre in coming years; stocks included." (Cliff Asness, founder of AQR Capital, demolished the idea that low rates justify paying more for equities in "Fight the Fed Model.") [Fun experiment: When a Wall Street pro tells you stocks are reasonable because bond yields are low, ask if he thinks bonds are attractively valued now. Chances are, the answer would translate to, "Stocks look cheap compared to something I think is wildly overvalued."] Bank of America Merrill Lynch last week lifted its S & P 500 target, applying the following logic: "Typically, in the later stages of a bull market, corporate earnings are cyclically elevated and the multiple that the market assigns to those earnings is often elevated as well. As a result, market prices can become significantly overvalued relative to their intrinsic fair value, and this divergence can last for years. "Thus, we would highlight the distinction between our year-end target of 2450 and our estimated intrinsic fair value of 2230. For investors with long time horizons, our long-term (year 2025) target of 3500, which is based solely on valuation, indicates a solid but below-average annual price return of 4-5% (or total return of 6-7%)." "Low future returns" are usually not a smooth ride, but a series of long trends, overshoots and nasty retrenchments. In this now-eight-year advance, the S & P has delivered more than 19 percent annualized with dividends reinvested. It doesn't owe investors much if anything now. But bull markets often give us more than we deserve – until they suddenly take some or all of the extra away.

Traders at the New York Stock Exchange.

Drew Angerer | Getty Images

The market is a constant argument over the right price to place on an unknowable future. Yet nearly all market players agree on one thing: U.S. stocks aren't cheap.

The disagreement surrounds just how expensive they are, whether it's justified and whether valuation "matters" for now.

There are many ways to portray how equities are valued versus companies' profits and their future cash flows.

Among the most conservative – some would say punitive – methods, is Robert Shiller's Cyclically Adjusted Price/Earnings ratio, based on the past 10 years' reported earnings for the S&P 500. That ratio is above 29, a level only exceeded in the past century during the late-'90s bubble years. (Of course, this measure has looked "too high" for much of the past decade, as the market has continued marching higher.)

Then there's the "trailing" and "forward" P/E. Based on last year's operating profits, the S&P is just above a 19 multiple; on the consensus forecast for 2017 results, a bit over 18.

Whatever gauge is used, stocks are more expensive than they've been at any point of this economic cycle and since the last major bear market ended -eight years ago this Wednesday. The immutable math of investing says the richer valuation you pay, the lower your expected long-term returns.

So why are investors willing to pay up for stocks at relatively stout valuations, in the form of heavy equity-fund inflows, during this impressively persistent phase of the rally?