High U.S. Stock Market Valuations Not A Headwind

The U.S. economy continues to mend, led by strength in housing starts – one of several indicators supporting our belief that another recession is unlikely.

With the S&P 500 Index rallying 10.8% in November – the 10th best month in the last 75 years –investors are beginning to think that valuations may be the bigger concern.

Despite the positive signs, some investors remain cautious. More than 65% of the 20.5 million U.S. workers who remain jobless are set to lose unemployment benefits after Christmas. Unless Congress passes a new stimulus bill, some fear this could lead to a dreaded double-dip recession.

In our view, though, the economy continues to show signs of an ongoing recovery and investor surveys show an uptick in bullish sentiment.

Americans have over $1 trillion in additional savings accumulated relative to pre-pandemic levels, which could provide a buffer.

Housing starts have been a bright spot, up 14% year-over-year and up 64% from April’s lows. Further upside exists too: the latest National Association of Home Builders (NAHB) Housing Market Index (HMI) – designed to lead housing starts by six months – reached an all-time high in November.

The markets are also benefitting from increasing clarity around two major points of uncertainty: the U.S. presidential election, and roll-out of a COVID-19 vaccine. A key measure of expected volatility, the VIX fell from 38.0 to 20.5.


Stocks are performing well, hitting historic highs, and a recovery in earnings in 2021, where consensus expectations are calling for more than 20% earnings per share growth for the S&P 500 Index, could have an even greater impact on equity performance.

Much of this rally has been powered by multiple expansion, leading many investors to worry as equities trade at 21.8 times the next 12-month expected earnings – well above the 16.1 times historical average.

Nevertheless, valuations may be better supported than commonly believed.

The market’s makeup helps. Cyclical groups, which tend to be more volatile and trade at lower valuations, are at their lowest levels in nearly 100 years. Meanwhile, less volatile sectors – with higher growth, greater stability and more defensive traits – are at their largest share of the benchmark ever. In a low growth environment, these characteristics reward investors with higher multiples.

The valuation of equities within the broad investment landscape also matters. Historically low interest rates have pushed some investors out of bonds and into stocks. The S&P 500 offers a dividend yield of 1.7%, comparable to corporate bond benchmarks. As more investors shift into equities in search of yield, this can push up equity valuations, even with no changes in earnings.

Equity valuations depend on the typical behavior of the stock market too. The three potential sources of return for equity investors are dividends, earnings growth (or loss) and changes in valuation multiples. More stable than earnings or multiples, dividends have steadied.

Stock prices tend to respond to new information faster than earnings expectations are revised. As a result, short-term returns tend to be more driven by multiples, while long-term returns tend to be more driven by earnings. Over 85% of one-month returns can be attributed to valuation changes, while this is true of only 25% over a one-year horizon.

It’s not unusual, coming on the heels of a recession, for multiple expansion to drive the first leg of a stock market rally. Earnings usually come through later. The typical pattern should play out in 2021.

While we expect multiples to gradually work lower in the coming months as earnings recover, equity valuations should not prove an impediment to further upside for long-term investors.

Jeffrey Schulze, CFA, is a director and investment strategist at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice.

Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.

All investments involve risk, including loss of principal. Past performance is no guarantee of future results.

©2020 Legg Mason Investor Services, LLC, member FINRA, SIPC. ClearBridge Investments, LLC, and Legg Mason Investor Services, LLC are wholly-owned subsidiaries of Franklin Resources, Inc.


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