Have US stock valuations become too high?

The US market has outperformed most other markets over the past several years. But this has now made the valuations of US stocks look 'expensive'. In 2023, the S&P500 index rose by 25%, while total underlying corporate earnings for the index only increased by 4%. In the first five months of this year, the index has risen by a further 12%, widening the gap between share prices and underlying corporate earnings.

A stock can fundamentally rise for two reasons: i) An increase in the company's earnings. ii) Or an increase in the company's valuation, often measured as the Price/Earnings multiple. While there has been positive support from corporate earnings, most price gains are driven by rising valuations.

The Price/Earnings multiple for the S&P500 has increased from around 17 times in early 2023 to over 21 times today. This is above the long-term average of just under 18 times. This means the shares have become 'more expensive' because investors now pay a higher price for the company's underlying earnings.

This comes at a time when we otherwise have high interest rates. When interest rates are high, the valuations of stocks should be lower, all else being equal. When bonds provide a return that is not far behind equities, the competition is tough. From a technical valuation point of view, the present value of the future earnings of stocks also falls when interest rates are high. Conversely, the market can better live with high valuations when interest rates are low. The current situation of high interest rates and high valuations is causing some concern but not panic.

The US market has positioned itself as one of the world's 'most expensive', which contrasts with Europe's relatively more modest valuation with a Price/Earnings multiple of only around 14 times. However, there are good reasons why the US has a higher valuation. Stronger economic growth and a huge tech sector are some of the reasons. Tech companies deserve higher valuations, better earnings potential, easily scalable business models and strong margins. The 'Magnificent Seven' stocks account for almost 30% of the total index value, and some of these stocks in particular have high valuations.

Meanwhile, Europe's valuations are rightly held back. This is due to higher debt levels, more cyclical companies, structurally lower growth and greater pressure on margins. We should not compare apples with pears. But the question is whether the 'US premium' of now almost 50% has become too large.

I am optimistic about the resilience of the large US stock market. However, the combination of already high profitability and high valuations limits the upside potential. Put simply, higher valuations have less room to rise when times are good. And more room to fall when fundamentals are weak.

For investors who are already heavily exposed to the US market, the 'cheaper' regions like Europe or Emerging Markets can be a sensible addition to the portfolio. There is more room for valuations to rise here and it can also be an 'insurance policy' against higher bond yields, which will put further pressure on valuations.

Jakob Westh Christensen, eToro Market Analyst