Stocks have been on an absolute tear following the pandemic-related selloff. The S&P 500 is up over 90% since the market bottomed on March 23rd of last year. By August, the index had fully recovered its losses and pushed to a new all-time closing high on 41 trading days since. Over the last month, however, the pace of gains has slowed dramatically. While some investors may fear this apparent loss of momentum, it would probably be a good thing for the stock market to take a breather.

Investors must understand that the stock market is forward-looking. Prices reflect current conditions but also incorporate expectations for how conditions will evolve in the future. This feature was on full display during the pandemic. The stock market selloff began in February, several weeks before cases accelerated and local officials began instituting lockdowns. Conversely, the market began to recover before the economic data even began to reflect the damage caused by the shutdowns. In each case, the market repriced itself ahead of forthcoming changes to the business environment.

Today, most traditional measures of valuation (how cheap or expensive the market is) suggest the stock market is richly priced. Evidence of this can be found in the chart below from JP Morgan. The grey line represents the forward P/E ratio, which divides the market’s current price by the estimated earnings for the next twelve months. The ratio indicates how many dollars an investor must shell out to participate in the earnings generated over the next year. The higher the grey line, the more expensive the market is. When the grey line resides above the highest dashed line (as it has for several months), the market is often considered overvalued.

S&P 500 Index: Forward P/E Ratio

In addition to the forward P/E ratio, the table at the top center summarizes how various other traditional valuation measures compare to their long-term averages. The majority of the measures offer the same conclusion: the market is expensive.

There are a variety of factors that may be contributing to the market’s high valuation. One reason may be that the market expects earnings growth to be higher than the forecasted earnings used in the forward P/E ratio. Recent evidence could potentially justify this expectation. According to an analysis published by FactSet, earnings growth during the 1st quarter of 2021 was dramatically higher than the initial estimates. Investors could be justified in paying a higher price for stocks today if they anticipate businesses will continue to outperform Wall Street estimates. In doing so, investors are pulling future returns to today. Businesses will then need to knock it out of the park in the coming quarters just to justify today’s price. If results end up being good, but not as good as investors are anticipating, prices would likely fall.

Another potential justification for higher stock market valuations is the current level of interest rates. The Federal Reserve has an extremely accommodative monetary policy stance, which includes holding short-term interest rates near 0%. In simple terms, when short-term interest rates pay investors next to nothing, there is an incentive to move further out on the risk spectrum in the search for a higher return. The stock market is a common destination for these return seekers and the increased demand results in upward pressure on prices. Going back to the JP Morgan chart, the last valuation measure in the table (top center of chart) illustrates the EY Spread (Earnings Yield Spread), which compares stock market valuation to current bond yields. Because yields (interest rates) are so low today, the EY spread actually makes the stock market look relatively underpriced, despite appearing overpriced by the other measures.

The Federal Reserve has repeatedly stated that it intends to keep interest rates near zero for an extended period of time. This offers a very real justification for the stock market’s current price. Over time, earnings growth should move valuation measures like the forward P/E ratio from over-priced to fairly-priced without the need for a market correction (selloff). If interest rates were to rise sooner than expected, stocks would lose a major justification for their current price level. This helps to explain why the market has been so jittery about recent inflation data. Excessive inflation could force the Federal Reserve to raise rates sooner and/or more aggressively than it has communicated to the market.

Any way you slice it, a slowdown in the pace of market gains is probably a good thing. Most metrics suggest the market looks expensive. If price appreciation continues to outpace business fundamentals, stock valuations could stretch further. Eventually, interest rates will normalize, which would eliminate a major justification for stretched valuations. Valuations can normalize from earnings outpacing price appreciation or by prices falling. Most investors would prefer the former.


  • According to data from FactSet, 95% of companies in the S&P 500 have reported earnings for the 1st quarter. 86% of these companies have reported earnings above analyst estimates, while 76% have reported revenue above analyst estimates. The YoY growth rate for companies that have reported, blended with the estimates of companies that have yet to report, increased to 51.9%. This blended growth rate is dramatically higher than what analysts were forecasting at quarter-end (23.7%) and would be the largest YoY growth rate since 2010 (55.4%). A faster than expected rate of earnings growth is a large positive for the stock market. Absent a commensurate increase in prices, a faster pace of earnings growth should put downward pressure on stretched valuation ratios.
  • Cryptocurrencies have been under significant pressure in recent days, with Bitcoin declining to as low as $32,000 over the weekend. Factors that precipitated the decline include Tesla’s announcement that it will no longer accept Bitcoin as a method of payment for environmental reasons and a crackdown on mining and usage in China. Bitcoin has retraced some of the losses from the recent lows reached on Sunday.
  • Economic data due later this week includes jobless claims and durable goods orders on Thursday and consumer spending and Personal Consumption expenditures (PCE – the Fed’s preferred inflation measure) on Friday. Inflation data will be of particular interest to investors for reasons discussed in the Story of the Week (above).



  • Don’t Bet Against Beijing’s Efforts to Smother Bitcoin (WSJ)
  • Bitcoin’s Trading Action Lately is Wild Even by Crypto’s Standards (CNBC)
  • The Fed this Summer Will Take Another Step in Developing a Digital Currency (CNBC)



  • Phil Mickelson, the People’s Champion, Was the Perfect Winner for this PGA Championship (Sports Illustrated)
  • Chernobyl Is Heating Up Again, and Scientists Aren’t Sure Why (ExtremeTech)
  • The Costly Pursuit of Self-Driving Cars Continues On. And On. And On. (NYT)


Source: Morningstar Direct.

Source: Morningstar Direct.



Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)


Source: MarketWatch

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Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 12+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. He is also responsible for portfolio trading, research and thought leadership as well as analytics and operational efficiency for the Firm's Financial division. He lives in Omaha, NE.

  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
  • BSBA, University of Nebraska, Lincoln, NE

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