Bank of America: U.S. stock valuations are high, but a return to the mean may take time

According to the analysis by the global research team at Bank of America, despite the current high trading levels of the U.S. stock market, investors should not expect valuations to quickly return to long-term average levels.

The strategy team led by Bank of America’s equity and quantitative strategist Savita Subramanian noted in a client report that "regardless of the valuation metric used, the valuation of the S&P 500 index is far above historical averages." They specifically mentioned that the risk premium of U.S. stocks—the difference between stock returns and the yield on 10-year U.S. Treasury bonds—is currently at a historical low and may decline further due to changes in the S&P 500 constituents.

The report pointed out that the composition of the S&P 500 index has changed significantly. Unlike the capital-intensive manufacturing companies that dominated in the 1970s and 1980s, today, 50% of the companies in the S&P 500 index are low-labor-intensive and asset-light firms, such as those in the technology, media, and healthcare sectors.

Compared to past economic cycles, the leverage levels of S&P 500 constituent companies are also lower. In previous cycles, debt was an important macro factor driving stock risk premiums, but this factor's influence has weakened. According to Bank of America's analysis, the current stock risk premium is below 2%, while the average over the past decade is about 5%. When the risk premium declines, it means that the additional returns from holding high-risk assets like stocks compared to ultra-safe assets like U.S. Treasury bonds are decreasing.

The Bank of America team warned that if the stock risk premium returns to its long-term average level, the S&P 500 index could fall by 50%. However, due to improvements in corporate efficiency, this scenario is unlikely to occur in the short term.

The Subramanian team also pointed out that the current level of stock risk premium is comparable to that of the 1980s and 1990s, as companies have responded to higher cost inputs by improving efficiency. This efficiency improvement has been aided by the widespread application of technological tools, such as automation, big data, and generative artificial intelligence (AI). The productivity of S&P 500 constituent companies has significantly increased, with the ratio of actual corporate income to the number of employees surpassing levels from decades ago.

The team further noted that future improvements in corporate efficiency are justifiable, especially with the support of technological tools. Technologies such as automation and AI will continue to help companies optimize operations This week, the sharp sell-off in the U.S. bond market has affected the financial markets. On Friday, the yield on the 10-year U.S. Treasury bond rose to 4.772%, reaching a new high since November 2023. The yield on the 30-year Treasury bond also climbed to 4.962%. This trend was driven by the strong non-farm payroll data recently released, prompting the market to lower expectations for interest rate cuts by the Federal Reserve this year.

Meanwhile, the U.S. stock market experienced significant declines this week. According to FactSet data, the Nasdaq Composite Index fell by 2.3%, the S&P 500 Index dropped by 1.9%, and the Dow Jones Industrial Average decreased by 1.9%.

This report provides investors with profound insights into the current market environment while emphasizing the long-term trends of corporate efficiency and technology-driven development. Although short-term volatility in the stock market is evident, changes in the composition of the S&P 500 and technological applications may continue to support the market's long-term performance