Chair Powell and the Federal Reserve recently delivered a larger-than-expected half-percentage point decrease in short-term interest rates, igniting another leg of the stock rally. Because of the aggressive first move from the Fed, markets have priced in a higher likelihood of avoiding recession and sent stocks to new highs.
Stocks and the Magnificent 7 continued their march higher this week. The Magnificent 7, consisting of Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), Apple (AAPL), NVIDIA
SPDR Dow Jones Industrial Average ETF Trust
(NVDA), Alphabet (GOOGL), and Tesla (TSLA), outperformed the S&P 500 on the week and are now only 5.1% below their early July highs. The S&P 500 is almost 22% higher year-to-date, while the S&P 500 technology sector is nearly 30% higher.
With the backdrop of the Fed rate cut cycle, resilient economic growth, and stocks closing at highs this week, are stocks overvalued?
Trying to value the stock market is simple on the surface but is never easy. Since shareholders own a piece of an operating company, not just a piece of paper, stocks are valued based on the expected future cash flows accruing to shareholders. Complicating the process and providing the occasional opportunity for investors, prices are also impacted by human emotion.
Based on a multiple of next year’s estimated earnings, also known as the forward price-to-earnings ratio, stocks do not look cheap relative to the past. However, historically, the price-to-earnings (P/E) ratio is correlated with return-on-equity (ROE), which measures how efficiently companies produce profits from the capital provided by their shareholders. Though ROE is down from its recent highs, it remains above average and argues for an above-average P/E ratio, assuming this elevated ROE is sustainable.
Warren Buffett has said, “The value of a business is the cash it’s going to produce in the future, discounted back to the present.” Free cash flow measures the cash left over after a company supports its operations and maintains or invests further in its business, providing a good measure of the money accruing to us as owners.
Free cash flow yield is the free cash flow divided by the stock price. Consistent with price-to-earnings, cash flow yield points to a stock market that is not cheap, though it has been more expensive at times in the past. This metric assumes free cash flow remains static, so it can also be interpreted as investors having more confidence that free cash flow will continue to grow. Indeed, investors should be willing to pay more for a company in which one can have high confidence that the corporate profits accruing to owners will continue to grow.
As a subset of the S&P 500, technology stocks are priced at an even lower free cash flow yield. This valuation premium reflects the optimism about the future of many of these companies and, as will be illustrated, the superior fundamentals of the group.
Like the exceptional return on equity noted earlier and supporting the rich stock valuations, profit margins are elevated relative to history. Profit margins measure the percentage of top-line sales that become bottom-line profits. As a business owner, higher profit margins, all other things being equal, are more valuable. Notably, the profit margins for the technology sector are close to double the market as a whole, which helps explain the premium valuation assigned by the lower free cash flow yield.
As noted, free cash flow yields look in the rearview mirror and don’t explicitly consider growth. Over the last five years, the S&P 500 has grown free cash flow per share at a 5.1% annualized rate, while the technology sector has grown at a much faster 8.6% annualized rate. Both are impressive growth rates considering that this timeframe includes the COVID-19 economic shutdown, which saw the U.S. economy shrink at a 32.9% annualized rate in the second quarter of 2020. Technology’s superior free cash flow growth further reinforces why those stocks have been dominant, and their valuation is above the S&P 500.
As Buffett noted, the last piece of the puzzle is to discount those future owner’s cash flows to the present using an interest rate. All other things being equal, valuations should be lower for the same stream of profits when yields are higher and vice versa.
Now that the Federal Reserve has begun reducing short-term interest rates, the expectation is that yields for longer-maturity bonds will also decline. Indeed, an analysis of past monetary easing cycles shows that stocks usually rose in the twelve months after the cuts started.
If one looks at how the more economically sensitive cyclical companies are performing versus the less sensitive defensives, stocks currently assign a lower risk of recession. In addition, consensus S&P 500 earnings estimates for 2025 call for 15% growth, according to FactSet. The soft landing does seem like how things should play out, but it is far from a certainty. Warren Buffett spoke to the situation when he said, “It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance.” In other words, prices are usually high when the majority are optimistic.
So, where does this leave us in our answer to the question of stock valuation? It isn’t an easy or straightforward answer. As a means of defense, even Warren Buffett has said, “In the business world, the rearview mirror is always clearer than the windshield.”
Investors have rightly sent stocks higher, particularly technology stocks, based on improving fundamentals, but that is the past. If one believes that the economy continues to chug along and free cash flow, perhaps driven by artificial intelligence, continues to grow at a robust pace, then stocks could be underpriced. Further, the leading technology companies have dominant competitive positions, and delivering intangible goods allows for profit margins and earnings growth rates that were not previously possible. There are reasonable arguments that artificial intelligence can lift profits across many industries, not just the technology sector.
The challenging part is the current starting line of exceptional profit margins and above-average valuations, which leaves less margin for error since the future free cash flows matter to the valuation of businesses. In addition, the COVID-impacted economic cycle likely leaves our typical economic indicators less effective, so confidence in forecasts should be less than usual.
Though it doesn’t feel that way, the risk of eventual disappointment is higher in stocks when valuations are above average, and forecasts are rosy. For long-term investors who can withstand the inevitable volatility, the discussion of overvaluation is moot since stocks have provided the highest after-inflation returns of any asset class despite the ups and downs throughout history.
Since the short-term path of stocks is always unknown and subject to human emotion, investors should be mindful of their asset allocation and risk tolerance. It is an excellent time to consider rebalancing to an appropriate risk level after the robust stock gains, especially in light of possible higher capital gains tax rates next year. In addition, owning some high-quality and less economically sensitive defensive stocks is analogous to buying an umbrella when it is sunny. The purchases are cheaper than when it rains, and investors will be happy to have them if it storms. Because some dominant technology companies have exceptional fundamentals and long-term outlooks, abandoning them altogether, barring evidence to the contrary, is unwise.
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