Liz Looks at: Bubbles and Valuations

By: Liz Young · May 20, 2021 · Reading Time: 4 minutes

If It Doesn’t Burst, Is It Even a Bubble?

Since the market bottom on March 23, 2020, the S&P 500 is up over 80%. The 12-month forward price-to-earnings (P/E) ratio, a widely used measure of valuation, is 21.0—well above its 5-year average of 17.9 and 10-year average of 16.0. By these measures, it’s no wonder people worry that the market is overvalued and overbought, it’s gone too far too fast, or that the so-called bubble could burst at any moment.

But what if the bubble doesn’t have to burst? What if air just slowly seeps out until we get back to average P/E levels? And what if it’s because the E (earnings) grows faster than the P (price), but they both still grow? Then was it really a bubble at all?

For much of 2020, stock market momentum drove valuations higher, fueling concerns that there was too much monetary and fiscal policy juice behind the rally and not enough actual corporate strength.

Now that we’re approaching a new economic regime, one with increasingly good data and decreasing fiscal and monetary support, corporations have to show their mettle. One of the ways they can do this is through earnings.

We are almost through earnings season—the period when companies report their results for the previous quarter—and on balance, Q1 was a darn good one. As of last Friday, 86% of S&P 500 companies beat their Q1 earnings estimates. If that percentage holds, it will be the highest number of companies beating estimates since FactSet began tracking this metric in 2008.

Q1 earnings growth is on pace to come in at +50%, and the full year 2021 earnings growth is projected to be +33% (slightly amplified due to unusually low earnings in 2020). Nevertheless, the expectations are high—and the actual results have been even higher.

If we continue on this trajectory, and if the S&P 500 ekes out even modest single-digit gains, measures of valuation like the P/E ratio should slowly drift downward, and already have this year. Broadly, the index can generate return, companies can generate earnings, and nobody gets hurt. It may not be without short-term corrections, but over the longer-term, it’s possible.

Remember the most hated bull market of all time after the Global Financial Crisis? Hated because people doubted its staying power and were underinvested. It lasted more than 10 years. Be diversified, be prudent, but be present. You must be present to win.


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