S&P 500 valuations are higher than the 1929 (Black Friday) Wall Street crash and the October 1987 (Black Monday) crash. The Dotcom bubble is the only time in the last 120 years that the ratio between Price and highest trailing earnings (PEmax) was higher.
PEmax eliminates distortions in the price/earnings multiple caused by sharp falls in earnings during recessions. The current multiple of 26.93 compares the index at December 31, 2020 to highest trailing earnings of 139.47 (for the 12 months ended December 2019) rather than expected earnings of 95.22 for the 12 months ended December 2020. Highest trailing earnings in such a case are a far better reflection of future earnings potential than more recent results.
Payback model
Using our payback valuation model, we arrive at a fair value estimate of 2331 for the S&P 500 based on:
- highest trailing earnings of 139.47;
- a long-term growth rate of 5% (the highest nominal GDP growth achieved in recent years was 6.0% in Q2 2018); and
- a payback period of 12 years — normally only used for stable companies with a strong defensive market position.
The LT growth rate required to match the current index value (3851) is 12.0%. The only time such a growth rate was achieved, post WWII, is in the 1980s, when inflation was in double-digits.
Conclusion
Stock prices are in a bubble of epic proportions. Risk of a major collapse remains elevated.