Are U.S. stocks expensive or not?
UBS believes that the valuation of the U.S. stock market is indeed somewhat high, but not excessively so, supported by four main factors: stock market valuations tend to rise during non-recession periods, the increasing share of technology companies in the U.S. stock market, improvements in company cash flows, and the current decrease in capital costs
Valuation levels are higher than the 30-year average; how expensive are U.S. stocks really? Will they continue to rise?
On December 9th, UBS strategist Jonathan Golub and his team released a report stating that the valuation of the U.S. stock market is indeed high, but not excessively so. Currently, the risk of recession in the U.S. economy has been controlled, and it is expected that the price-to-earnings ratio of the S&P 500 index will continue to rise by 2025.
Since the beginning of this year, the U.S. stock market has repeatedly hit new highs, with the current price-to-earnings ratio of the S&P 500 index at 22.2 times, which is 5.4 times higher than its 30-year average of 16.8 times. Although the bullish sentiment towards large-cap companies such as the "Seven Giants of U.S. Stocks" is pushing up the price-to-earnings ratio, it is important to note that even when calculated on an equal-weight basis, the price-to-earnings ratio of U.S. stocks still reaches 19.1 times.
Although high multiples are often seen as a bearish signal, investors should pay more attention to the reasons behind the high valuations. UBS believes there are four reasons:
- Stock market valuations tend to rise during non-recession periods;
- The proportion of technology companies in the U.S. stock market has significantly increased;
- Improvement in company cash flows;
- Current capital costs are lower.
In addition to UBS, Wall Street institutions have differing views on whether the U.S. stock market is overvalued—last Friday, top Wall Street economist David Rosenberg apologized for his bearish stance on U.S. stocks, last Thursday, Goldman Sachs liquidity expert Scott Rubner stated that U.S. stocks will rise again by the end of the year, and last Monday, the chairman of Rockefeller International Ruchir Sharma warned that U.S. stocks are in a bubble……
1. Stock market valuations tend to rise during non-recession periods
Many investors assume that stock valuations or equity risk premiums will revert to fair value; however, UBS's research shows that stock market valuations typically have an upward tendency during non-recession periods and will quickly correct during economic contractions.
Given that the risk of recession in the U.S. economy has been controlled, UBS expects that the price-to-earnings ratio of the S&P 500 index may continue to rise by 2025.
2. The Proportion of Technology Companies in the U.S. Stock Market Has Increased Significantly
UBS stated that 30 years ago, before the commercialization of the internet and the birth of smartphones, the market capitalization of technology companies in the S&P 500 index accounted for only 10%. Today, this proportion has grown to 40%. In this transformation process, technology companies have experienced faster revenue growth and higher profit margins compared to other types of companies—naturally leading to an overall increase in the valuation of the U.S. market.
According to the report, the current revenue growth, earnings before interest and taxes (EBIT) margin, and price-to-earnings (P/E) ratio for technology companies are 10.5%, 23.8%, and 28.2 times, respectively, while for non-technology companies, they are only 5.7%, 12.6%, and 18.9 times.
3. Improvement in Company Cash Flow
UBS indicated that over the past 30 years, the capital intensity of companies included in the S&P 500 index has decreased. Therefore, both technology and non-technology companies have significantly increased their cash flow, and higher free cash flow means that companies can return more funds to shareholders, making it very reasonable to achieve higher valuations in terms of P/E ratios.
4. Current Lower Cost of Capital
Currently, the yield on 10-year U.S. Treasury bonds is about 4.2%, which is 40 basis points higher than the long-term average of 3.8%, but the credit spread has decreased by 220 basis points. UBS stated that this means the cost of capital is 20% lower than the historical average.
When calculating the P/E ratio of the S&P 500 index, using the current lower cost of capital instead of the higher long-term average cost of capital would result in an additional 4.1 times in the P/E ratio of the S&P 500 index.
