Exuberant investors are behind extreme valuations

There is one thing that is abundant on both Wall Street and Main Street nowadays: optimism.

Investors are optimistic that U.S. corporations are capable of producing double-digit earnings growth over the next year, businesses are optimistic that consumers will continue to spend and consumers are optimistic because their wealth has grown due to higher house and asset prices full circle of life.

One metric that captures such optimism on Wall Street is stock market valuations. No matter which particular metric you choose, and despite the latest blockbuster earnings season, it has risen faster than underlying fundamentals since the economic expansion that started in 2009.

Stocks have been getting expensive for a while, however. Over the past three years, earnings per share of the S&P 500 index
SPX, +0.17%
has been virtually flat, while prices rose 30%. In finance the phenomenon is referred to as multiple expansion, or an increase in price-to-earnings ratio.

Multiple expansion is basically a measure of human emotion. The higher the P/E, the more optimistic people are, said Urban Carmel, former UBS analyst and author of the Fat-Pitch blog.

Based on valuations, investors have rarely been this optimistic. Price-to-earnings ratio based on 12-month forward earnings is at 17.6, the highest level since 2004, according to FactSet. P/E based on 12-month trailing earnings is at 20.23, also the highest level since 2004.

Another measure, the cyclically adjusted price-to-earnings ratio, better known as CAPE and developed by Yales Robert Shiller, is at 29. That measure was higher only twice over the past 140 years: in 2000, when it hit 44, and in 1929, when it hit 32.5. The long-term average is about 16.

High valuations are associated with lower long-term returns.

Read: Why long-term U.S. stock returns look dismal

According to investor surveys conducted by Shiller, about 40% of both institutional and retail investors view current stock prices as cheap, which is the lowest since 1999, when only a third of investors thought stocks were cheap. Yet at the same time more than 90% of investors expect prices to continue to rise for another year. That number is close to 100% among institutional investors.

Analysts at Bespoke, who said that this is exactly what irrational exuberance looks like, wrote that it is a negative for the market in the longer term.

As a general proposition, if a huge share of investors think that the market is expensive but are still optimistic, the markets psychology is fragile, the note said.

Over time, however, price-to-earnings ratio does normalize, either when prices fall due to corrections or when earnings expand faster than prices.

Wouter Sturkenboom, senior investment strategist at Russell Investments, is skeptical that earnings will expand consistently to outstrip valuations.

We suspect that profit margins will contract and revenue growth will disappoint, so our estimate for EPS growth is much more modest single digits for 2017. So, it will be a meaningful correction that will cause the PE to revert to the mean, Sturkenboom said.

Read: A slowdown in stock buybacks may be a bad omen

But until such corrections characterized by drops of 10% or more there is no reason not to expect further expansion in multiples.

Stock prices on the index level are driven by both fundamentals and emotions. In a typical expansion, its about half and half. In the latest expansion period from the middle of 2009, price appreciation in the S&P 500 was driven by the combination of earnings and multiple expansion, with the latter accounting for about 40%, Carmel said.

The latest optimism among investors could be attributed to hopes that President Donald Trumps administration and the Republican-controlled Congress would successfully implement tax and regulatory reforms that would spur higher economic growth.

Optimism among businesses and consumers has risen, even though not much changed in terms of reforms. They are still just ideas. But there is another reason people are buying stocks alternatives, such as bonds, have very low yields, almost forcing people into stocks, said Sturkenboom.

Over the short term, valuation is a risk indicator; over the long term, its a return indicator. Ignoring high valuations right now is irresponsible. We view stocks at current levels not worth the risk, Sturkenboom said.

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