CICC: Are U.S. stock valuations too high?

Source: CICC Insights. Original title: "CICC: A New Perspective on Assessing U.S. Stock Valuations."

Last week, the NASDAQ index broke through the 20,000-point mark for the first time. Although concerns about high valuations and potential economic stagflation following Trump's presidency remain, the U.S. stock market has continued to "sing high" after the Fed's interest rate cut in September and especially after the November elections, with the three major indices repeatedly hitting new highs. Despite these concerns not reversing the upward trend of U.S. stocks, they have indeed increased alongside the market's new highs. So, how high are U.S. stock valuations at their current position? What level of valuation can the current growth and liquidity environment support? How should we view the valuation issue of U.S. stocks? In response, we analyze the current valuation situation of the U.S. stock market from four perspectives: longitudinal comparison with historical levels, horizontal comparison with other assets, internal disaggregation of sectors and industries, and dynamic consideration of the interest rate environment through multidimensional indicators.

Chart: The three major U.S. stock indices repeatedly hit new highs

Data source: Bloomberg, CICC Research Department

Overall, whether comparing historically or with other assets, it is undeniable that U.S. stock valuations are relatively high, even appearing "extreme." However, the aforementioned perspectives are merely static thinking that assumes historical trends and relationships with other markets are fundamentally stable and mean-reverting. If we dynamically consider the interest rate and growth environment, especially the relative changes in costs and returns, current U.S. stock valuations are far from being as "extreme" as they seem, and may even be undergoing a trend change, for example, high-valued leaders and NASDAQ earnings contributions are actually higher than those of undervalued price sectors. However, in the short term, the expansion space for valuations is limited, and earnings dominate the market space. Under baseline scenarios, we estimate a 10% earnings growth for U.S. stocks in 2025, corresponding to an S&P 500 index level of 6300-6400.

1. Longitudinal Comparison with Historical Levels: All Dimensions Are Significantly Above Average

Through a longitudinal comparison of the valuation levels of major U.S. stock indices, we find that for different indices, from different indicators, and at different time periods, the current valuation levels are significantly above average. Specifically:

► From a static valuation perspective, the current static P/E of the S&P 500 is 27.2 times (previous high on April 29, 2021, 32.9 times), far above the average of 16.9 times since 1954; even compared to higher valuation phases since 1990 (average of 20 times), the current level is not cheap, being 1.6 standard deviations above the average since 1990, at the 91st percentile. The current static P/E of the NASDAQ is 47.8 times (previous high on December 28, 2020, 81.4 times), above the average since 2001 by 1 standard deviation, at the 90th percentile. The current static P/E of the Dow Jones is 34.5 times (previous high on April 11, 2021, 32.6 times), above the average since 1993 by 3.1 standard deviations, at the 99th percentile. However, the limitation of static valuations is that they do not consider future earnings expectations of the market, which can lead to upward bias in favorable growth prospects; therefore, we further consider dynamic valuations Chart: The current static P/E of the NASDAQ Index is 47.8 times

Source: Bloomberg, China International Capital Corporation Research Department

Chart: The current static P/E of the Dow Jones Index is 34.5 times

Source: Bloomberg, China International Capital Corporation Research Department

Chart: The current static P/E of the S&P 500 Index is 27.3 times

Source: Bloomberg, China International Capital Corporation Research Department

► From a dynamic valuation perspective, the current dynamic P/E of the S&P 500 is 22.7 times (previous high on September 2, 2020, 23.4 times), which is also higher than the mean of 16.6 times since 1990 by 1.8 standard deviations, placing it at the 94th historical percentile. In addition, the dynamic valuations of the Dow Jones, NASDAQ, and MAAMNG (technology leading stocks including META, Apple, Amazon, Microsoft, NVIDIA, Google) (21.2 times, 29.5 times, 31.4 times vs. previous highs of 22.7 times on June 8, 2020, 33.6 times on December 13, 2023, and 39.6 times on August 25, 2020) are also above their historical average levels (16 times, 14.8 times, 24.5 times), at the 95%, 89%, and 84% percentiles respectively, indicating that even considering future earnings expectations, U.S. stock valuations are not cheap.

Chart: The current dynamic P/E of the S&P 500 is 22.7 times, above one standard deviation of the historical mean

Source: Bloomberg, China International Capital Corporation Research Department

Chart: The current dynamic P/E of technology leading stocks is 31.5 times, above the historical mean

Source: FactSet, China International Capital Corporation Research Department

Chart: The current dynamic P/E of the Dow Jones Index is 21.2 times, above the historical mean

Source: Bloomberg, CICC Research Department

Chart: The current dynamic price-to-earnings ratio of the NASDAQ Index is 29.5 times, higher than the historical average.

Source: Bloomberg, CICC Research Department

► From other indicators, such as P/B, PEG, EV/EBITDA, P/FCF, P/Sales, the valuation level of the S&P 500 is also higher than the historical average over different time periods, especially for static valuation indicators such as static P/B, EV/EBITDA, and P/FCF, where the degree of deviation from the average level has exceeded 2 standard deviations (P/FCF is the highest, already above the average by 2.9 standard deviations; static P/B is next, above the average by 2.5 standard deviations). However, the PEG, which dynamically considers future earnings expectations and growth, although also above the average, has a smaller degree of deviation, ranging from 1.4 to 1.8 standard deviations.

Chart: Comparison of various valuation indicators of the S&P 500 Index

Source: FactSet, Bloomberg, CICC Research Department

It should be noted that although the above indicators show that the current valuation is significantly higher than the historical average, the longitudinal comparison to its historical level implies the assumption of mean reversion in valuation. However, the internal and external economic environment, interest rate environment, and industrial trends vary greatly across different periods. Therefore, a simple comparison that disregards the macro and market environment is not rigorous and can even be misleading; thus, it should not be fully trusted but can serve as a reference. Additionally, the digestion of high valuations does not necessarily have to be completed through a significant decline in asset prices; continuous improvement in earnings can also lead to a marginal decline in valuations. For example, in the first half of this year, the MAAMNG index's earnings expectations were revised upward, and dynamic valuations fell below the historical average plus 1 standard deviation.

II. Horizontal comparison with other assets: U.S. stocks are also not cheap

If the longitudinal comparison to history uses historical experience as a "reference frame" and assumes mean reversion as the underlying hypothesis, then the horizontal comparison with other assets uses other assets as a "reference frame" assuming a relatively stable relationship between the two. Upon closer examination, this comparison method also has significant issues, but it does not prevent us from using it as a reference. Specifically:

► Comparing the deviation of global market valuations: Among major global markets, U.S. stocks (MSCI U.S. Index) currently have a valuation (12-month dynamic P/E) that is significantly higher than its historical average deviation (z-score), already exceeding 1 standard deviation above the average. In contrast, valuations in Europe, Hong Kong stocks, overseas Chinese stocks, BRICS countries, and South Korea remain below historical averages Chart: Current valuation level of the US stock market is above one standard deviation compared to its historical average

Source: Bloomberg, China International Capital Corporation Research Department

► Comparison of premiums and discounts with other markets: Using Europe, Japan, and emerging markets as comparison benchmarks, we find that the current valuation of the US stock market (S&P 500) has premiums of 1.09, 1.65, and 1.82 times compared to the Nikkei 225, Europe’s Stoxx 600, and MSCI Emerging Markets, respectively, all significantly higher than the average premiums since 2000 (0.9, 1.2, and 1.6 times, respectively). In other words, the degree of overvaluation of the US stock market relative to Japan, Europe, and emerging markets has also exceeded historical levels, although it remains below the previous highs of premiums over the Nikkei 225 and Europe’s Stoxx 600 (1.5 times on November 17, 2021, and 1.8 times on March 28, 2024).

Chart: Compared to the Japanese market, the valuation of the US stock market is also significantly high

Source: FactSet, China International Capital Corporation Research Department

Chart: Compared to the valuations of Europe and emerging markets, and considering historical premium levels, the relative valuation of the US stock market is significantly high

Source: FactSet, China International Capital Corporation Research Department

► Bonds: The relative strength relationship between stock and bond valuations can be illustrated by comparing dividend yields and bond yields. Currently, the 12-month dynamic dividend yield of the S&P 500 Index (1.24%) is less than one-third of the yield on the US 10-year Treasury bond (4.27%), with a dividend yield/bond yield ratio of 0.3 times, which is a historical low since 2001, only half of the previous low point (0.6 times on October 3, 2018).

Chart: The current 12-month dynamic dividend yield of the S&P 500 Index is significantly lower than the yield on the US 10-year Treasury bond

Source: Bloomberg, China International Capital Corporation Research Department

► Gold and oil prices: Compared to commodities, using crude oil and gold for pricing, the current S&P 500 Index level corresponds to 67 times the Brent oil price and 2.6 times the gold price, lower than previous highs (144 times Brent oil price on April 27, 2020, and 2.7 times gold price on January 3, 2022). Although there is a gap compared to historical extremes, both are higher than the average levels of 31 times and 1 time since 1960 and 1928, respectively Chart: In terms of crude oil and gold pricing, U.S. stocks are already expensive.

Source: Bloomberg, China International Capital Corporation Research Department

► Economic Scale: Comparing the market capitalization of the S&P 500 with the nominal GDP of the United States, that is, the securitization rate, the current ratio is 2.8, the highest since 2000, exceeding the previous peak (December 31, 2021, 2.2 times), while the average since 2000 is only 1.1 times.

Chart: Comparison of total market capitalization and U.S. GDP, U.S. stocks are also expensive.

Source: Bloomberg, China International Capital Corporation Research Department

The limitation of horizontal comparison with other assets also lies in the assumption that the relative valuation levels between different assets are "mean-reverting," without considering the paradigm shifts in the strength relationships between different markets and assets. In the past three years since the pandemic, the "three macro pillars" that the U.S. has "accidentally" formed: large fiscal (post-pandemic fiscal stimulus), technological innovation (AI industry chain), and global capital rebalancing (Russia-Ukraine situation and Chinese economy), have created a continuous driving force that supports U.S. growth and the U.S. stock market's positive feedback loop, also widening the gap between U.S. and non-U.S. assets. This can also be evidenced by the continuous inflow of funds and the strengthening of the dollar over the past three years. This situation has many similarities with the "Reagan cycle" 40 years ago, during which the dollar rose by 100% (from 80 to 160) between 1981 and 1985, therefore, such a trend change cannot be captured by simple historical levels (《 2025 Outlook: The Path to Restarting the Credit Cycle》).

III. Internal Structure of U.S. Stocks: Significant Head Concentration Effect, but High Valuations Are Also Supported by Earnings

Looking at the valuation distribution within U.S. stocks, most sectors' valuations have already exceeded historical average levels by nearly one standard deviation, especially growth-oriented sectors which have higher valuations, and there is a significant head concentration effect in market capitalization. However, high valuation sectors have stronger earnings support than low valuation sectors. Specifically,

► Different Styles: From a dynamic valuation perspective, the Nasdaq index, representing growth style, is at 29.5 times, and the MAAMNG index is at 31.4 times, while the S&P 500 index is at 22.6 times, and the value-oriented Dow Jones index is at 21.2 times Chart: The most significant valuation expansion this year has occurred after September from different time periods.

Source: Bloomberg, China International Capital Corporation Research Department

► By Sector: In the S&P 500, all sectors except energy currently have a 12-month forward valuation exceeding the average since 2001, with consumer staples, financials, and IT sectors currently at over the 95th percentile, while energy and real estate sectors are below the 60th percentile.

Chart: All sectors of the S&P 500 are above the average except for energy.

Source: FactSet, China International Capital Corporation Research Department

► Concentration at the Top: Currently, the concentration effect in the U.S. stock market is strong, with a higher market capitalization concentration than during the 2000 internet technology bubble. The dynamic P/E of the MAAMNG index is 31.4 times, while the S&P 500 excluding MAAMNG has a valuation of only 19.6 times, and the S&P 500 index is at 22.6 times. The market capitalization of leading tech companies (MAAMNG) accounts for 30% (vs. the peak of 15.6% during the internet technology bubble), but the concentration of market capitalization is supported by certain revenue and profitability. The revenue, operating cash flow, and net profit of leading tech stocks account for 12.3%, 24.1%, and 28.4% of the overall comparable non-financial companies, respectively, which is more than double the peak ratios of 5.3%, 9.2%, and 13.2% during the internet technology bubble.

Chart: The current dynamic P/E of the S&P 500 excluding the MAAMNG index is 19.6 times.

Source: Bloomberg, China International Capital Corporation Research Department

Chart: The market capitalization of leading tech companies (MAAMNG) accounts for as much as 30% of the total market capitalization.

Source: Bloomberg, China International Capital Corporation Research Department

Chart: MAAMNG's revenue share is 12.3%.

Source: FactSet, CICC Research Department

Chart: MAAMNG's operating cash flow accounts for 24.1%

Source: FactSet, CICC Research Department

It should be noted that the valuation differences within the U.S. stock market actually reflect more of the earnings differences. Analyzing the performance of U.S. stocks this year, there is a clear divergence among different style indices, with growth style driven by earnings and value style driven by valuation. For example, in the NASDAQ's 31.1% increase, earnings contributed 21.5 percentage points, nearly 70%; the leading technology index MAAMNG had earnings contribution exceeding 70% (earnings 36.4% vs. increase 49.7%); in the S&P 500's 26.5% increase, valuation and earnings contributed equally (13.5% vs. 11.5%); the Dow Jones saw valuation expansion dominate (16.1% vs. 1.2%). This is also true at the sector level, where cyclical sectors such as energy, real estate, materials, and industrials mainly contributed through valuation expansion, while growth sectors like IT contributed mainly through earnings. From the perspective of the driving force behind valuation expansion, it mainly comes from the decline in risk premium, with the contribution of the risk-free interest rate being negative.

Chart: Cyclical sectors such as energy, real estate, materials, and industrials mainly contributed through valuation expansion

Source: FactSet, CICC Research Department

Chart: Leading technology stocks this year mainly contributed through earnings, exceeding 70%

Source: FactSet, CICC Research Department

Chart: In the S&P 500's performance this year, valuation expansion and earnings contributions are basically equal

Source: FactSet, CICC Research Department

Chart: The Dow Jones index's performance this year is mainly driven by valuation expansion, contributing almost all of the index's performance

Source: FactSet, CICC Research Department Chart: The performance of the NASDAQ index this year is primarily driven by profit contributions, accounting for nearly 70%

Source: FactSet, CICC Research Department

IV. Evaluating Valuation with a "New Perspective": Rising Natural Rates Offset the Increase in Real Rates, which is the Core Factor for Higher Valuation Pricing

In the above text, we analyzed the high valuation of U.S. stocks from three dimensions: vertical comparison with historical levels, horizontal comparison with other assets, and dissection of internal structure. However, these three methods are all "static thinking." If we consider the dynamic relationship between interest rates and growth environment, especially the relative changes in costs and returns, the current valuation of U.S. stocks is far from being as extreme as it seems.

Interest rates are one of the pricing factors for risk assets. According to the DCF model, the discount cost of future cash flows includes both risk-free returns and risk premiums. We found that using real interest rates to explain valuation pricing is better than using nominal interest rates, and using relative interest rates yields even better results. A simple example is that if the equity risk premium (ERP) calculated using a static method is nearly zero, it is completely unreasonable. Experience shows that the dynamic price-to-earnings ratio of the S&P 500 exhibits a more significant negative correlation with relative interest rates, meaning that relative interest rates can better measure the cost of capital and influence investors' valuation center for risk assets.

Chart: The trends of nominal interest rates, real interest rates, and relative interest rates were basically consistent during the period of stable inflation from 2000 to 2020

Source: Bloomberg, CICC Research Department

Chart: The equity risk premium of the S&P 500 measured by relative interest rates has not fallen to the lowest level since 2000

Source: Bloomberg, CICC Research Department

Chart: There is a positive correlation between nominal interest rates and the dynamic valuation of the S&P 500

Source: Bloomberg, CICC Research Department

Chart: There is a negative correlation between real interest rates and the dynamic valuation of the S&P 500, but the correlation is not high

Source: Bloomberg, China International Capital Corporation Research Department

Chart: There is a negative correlation between relative interest rates (HLW model) and the dynamic valuation of the S&P 500, with a correlation higher than that of nominal and real interest rates.

Source: Bloomberg, China International Capital Corporation Research Department

Chart: There is a negative correlation between relative interest rates (LM model) and the dynamic valuation of the S&P 500, with a correlation higher than that of nominal and real interest rates.

Source: Bloomberg, China International Capital Corporation Research Department

The natural interest rate has risen rapidly in the short term (fiscal stimulus, AI, and other factors have caused output and inflation to exceed trends), especially the widening gap with real interest rates, indicating that returns are rising faster than costs, which is the core factor allowing valuations to be priced higher. Estimates of equity risk premium show that considering the short-term rise in natural interest rates, the Richmond Fed's LM model calculates the natural interest rate to rise to 2.53%, with a gap of only 0.93% from the 1.6% real interest rate, significantly offsetting the cost increase as the discount rate, resulting in an S&P 500 equity risk premium (measured by the LM model) of 5.94%, which is still significantly distant from the 2.53% during the 2000 internet technology revolution, 4.96% during the 2009 financial crisis quantitative easing, and 4.09% during the 2020 COVID-19 fiscal stimulus period, thus not appearing extreme. Of course, if the rise in natural interest rates cannot be sustained or is even falsified, such as a reversal in the AI industry trend, then the valuation pricing will naturally revert to traditional static methods, which would be more "extreme."

Chart: The mean reversion characteristics of equity risk premium measured by nominal and real interest rates are not significant.

Source: Bloomberg, China International Capital Corporation Research Department

Chart: Considering the short-term rise in natural interest rates, the equity risk premium (measured by the LM model) has not yet fallen to historically low levels.

Source: Bloomberg, China International Capital Corporation Research Department

V. Market Space: Limited Expansion Space for Valuation, Profitability is Key to Future Trends

The further expansion space for valuation is limited. Given the current inflation (we expect U.S. inflation to bottom out in mid-2025) and the interest rate cut path (we estimate that the Federal Reserve needs to cut rates 3-4 more times, with a terminal rate of 3.5-3.75%), we expect the reasonable central tendency of the 10-year U.S. Treasury yield to be around 3.8-4% At the same time, the risk premium measured by relative interest rates is also at a historical low (the LM model is at the historical 30th percentile, and the HLW model is at the historical 5th percentile), indicating that there is relatively limited room for further decline. We estimate that the dynamic valuation may slightly retreat to around 21.

Earnings are the key variable for future trends and determine the future space of the U.S. stock market. Under the baseline scenario, combining the U.S. growth path (economic stabilization and recovery gradually by mid-2025) and the growth expectations for overseas income (30-40% of overseas income), we estimate that the earnings growth rate of U.S. stocks may reach 10% in 2025, slightly higher than this year's 9%. Of course, in our assumptions, the AI industry trend continues to maintain optimistic sentiment and high profit margins. At the same time, Trump's tax reform is expected to boost U.S. earnings by 3-4 percentage points, but whether this can be reflected in 2025 earnings will depend on the progress of policy implementation. Combining the above valuation estimates, we expect the S&P 500 index to be between 6300 and 6400 (《 How Much Space Is Left for U.S. Stocks?》). However, if domestic demand stimulation and technology industry performance fall short of expectations or weaken, or if inflationary policies are implemented more rapidly after Trump's inauguration, raising concerns about stagflation, in a pessimistic scenario, we expect the S&P 500 index to be between 5700 and 5900 (《 Path Simulation of Trump's Policies and Trades》)