- Stock market valuations, by one measure, have reached a high that has only been higher a few times in history.
- Stock prices appear historically high compared to government bonds, according to PIMCO and GAM Asset Management.
- Optimistic market expectations for future corporate earnings may “be met with disappointment,” PIMCO says.
After a rally that defied high interest rates and calls for a recession, stock valuations are now approaching levels seen before the biggest market crashes in history – at least by one measure.
A proven way to assess whether a stock is fairly valued is to compare it to government bonds, which are considered one of the safest forms of investment.
According to experts from PIMCO and GAM Asset Management, shares look historically expensive.
A key measure of the wealth of stocks relative to debt is the so-called equity risk premium – i.e. the additional return on stocks compared to Treasury bonds.
That rate has fallen this year, pointing to stretched stock valuations to levels seen during the Great Depression in the 1930s and the dot-com bubble in the late 1990s.
“Digging deeper into historical data, we find that there have been only a few times in the last century when U.S. stocks have been more expensive compared to bonds – such as during the Great Depression and the dotcom crash,” PIMCO portfolio managers Erin Browne, Geraldine Sundstrom and Emmanuel Sharef they write in a recent research note.
“History suggests that stocks are unlikely to remain as expensive compared to bonds.”
According to Julian Howard from Swiss GAM Asset Management, the historically low equity risk premium discourages investing in shares. This means that stocks offer investors little incentive to choose them over risk-free assets such as government debt – and this can discourage potential buyers.
“The equity risk premium is very, very low. It’s actually almost negative right now,” Howard said in a comment on the GAM website.
“And that’s a big problem because it says you don’t really need to invest in stocks in the short to medium term because if you invest in six-month T-bills that give you a completely risk-free 5.5%, that’s actually a risk reward that is completely unbeatable,” he added.
U.S. stocks are on track for their best month of the year amid expectations that the Federal Reserve may have ended interest rate hikes at a time when the economy remains resilient and inflation has eased.
The S&P 500 index rose 7.4% in November, taking its year-to-date gain to 17.3%, amid optimism that corporate profits will remain strong in the coming quarters.
However, PIMCO warns against this prospect.
“We believe that solid future earnings expectations are likely to be met with disappointment in the face of a slowing economy, which, combined with elevated valuations in much of the market, warrants a cautiously neutral view on stocks, favoring quality and relative value opportunities” – Browne, Sundstrom and Sharef wrote.
