Are Stocks Overvalued?

Are Stocks Really Overvalued?

We’ve written about the Magnificent Seven stocks being the force behind the market’s gains this year. And in light of their eye-catching returns and the overall index’s compelling bull market performance, it would be easy to believe that stocks are overvalued. But are they?

The chart below shows two valuation measures for the S&P 500 index as well as its 10 largest stocks and the other 490-plus equities in the index.

The first measure illustrates that future earnings per share (EPS) for the 10 largest stocks in the S&P 500 is estimated at 18.8%. That’s an impressive yet arguably unsustainable rate. A more reasonable 11.5% is estimated for the index as a whole, and the figure is 9.8% for the index minus those 10 stocks. For historical context, the average annual EPS for the S&P 500 over the last 20 years has been 8.4%.

By that measure, earnings are expected to be higher than average over the next 12 months. However, given that we’re in a bull market and the economy is expanding (GDP growth was a higher-than-expected 2.6% in the second quarter of 2023), it’s no surprise that earnings have been robust and appear poised to grow.

The second valuation gauge we’ve charted is forward price-earnings (P/E) ratio estimates. This is a simple comparison of the price of a stock or index against its earnings (price divided by earnings). The trend is similar to what we observed in EPS—the 10 largest stocks’ P/E ratios are inflated—but the ratios for the index overall and the index minus those 10 stocks are significantly lower.

In this case, the data points to the majority of the S&P 500 being fairly priced if not undervalued. The 25-year-average P/E for the entire index is 16.8, below the current forward estimate of 17.7. But once you remove the 10 largest stocks, the 490-plus remaining index components have a reasonable valuation of 15.3.

Given that the average bull market from 1929 onward lasted 1,011 days and generated a return of 114%, the fact that we’re only 280 days in with a 28% gain gives us confidence that opportunities remain for investors to see additional growth—at a reasonable price to boot. And even if the Magnificent Seven falter, or if the trend shifts to favor lagging segments of the market, today’s prices indicate that most of the market is a relative bargain.

When To Buy a Second Home

It’s the heart of summer—time for a vacation. This is also a time when we hear from clients wondering if this is their year to buy a cottage on the beach or in the mountains. With home prices hovering near historic highs in many areas and the price of seasonal rentals trending lower, this question is more complex than ever. We’re here to help.

Before you commit, consider how a second home fits into your long-term financial plan by asking yourself these questions.

Will I need a mortgage? Higher mortgage rates have pushed some buyers to the sidelines. Those same high rates make trading up more expensive for existing homeowners, keeping inventory low. And mortgage rates are steeper for second homes because lenders consider the default risk to be greater. Things may change later this year if inflation continues to ease and interest rates ultimately decline.

What’s my time horizon? If you intend to hold on to a property as a long-term investment or family legacy, its value may appreciate significantly, potentially making up for higher interest payments. And when interest rates eventually drop, you can refinance. Conversely, if you don’t see yourself keeping a house for at least three years, it may not appreciate enough to justify even the transaction costs of buying. Renting may make more sense.

Do I know the total costs? A home adds fixed expenses to your budget, including property taxes, insurance premiums, mortgage payments, maintenance and utilities. And it’s prudent to consider climate-related costs: If you are looking to buy near the water, you may need flood and hurricane insurance. Remember to keep all of these costs in mind.

Have I thought about taxes? You can claim tax deductions for mortgage interest, property taxes and rental expenses, but you’ll need to pay taxes on the income if you plan to rent your home for more than 14 days in any calendar year. We can help you think through your tax strategy.

Sticker shock aside, you may decide that a second home would dramatically elevate your quality of life. That alone is a decent reason to proceed if you find a property that fits your finances. If you’re on the fence, we’re here to help crunch the numbers and offer advice. Let us know!

Adviser Market Update

• The markets and economy are sources of optimism based on recent data, which is why Fitch’s downgrade of the U.S. government’s credit rating Tuesday was a surprise. Citing political dysfunction in Washington and heightened debt burdens, the ratings firm moved America’s credit from the top “AAA” grade to “AA+.” Global markets sold off on the news. While deficit challenges will undoubtedly recur in D.C., we have no concerns about America’s ability to pay its bills nor its safe-harbor investment appeal globally.
• With growing consensus that the Federal Reserve may have orchestrated a soft landing, traders pushed stocks to a fifth consecutive monthly gain in July. Even better, the 3.1% advance by the S&P 500 index last month went beyond the Magnificent Seven stocks that propelled the market earlier this year. Each of the index’s 11 sectors were up in July. This suggests that investors have picked up on a theme we’ve been supporting: Despite the S&P 500’s healthy returns this year, there are areas of opportunity where stock prices remain attractive and may still have room to run.
• Although the Fed raised rates another 0.25% at last week’s policy meeting, Chair Jerome Powell said that the central bank is no longer forecasting a recession. Citing “the resilience of the economy,” Powell noted signs that inflation is coming down “without any real costs” in the job market—exactly what you’d hope to see in a soft-landing scenario. Still, this doesn’t mean a recession is off the table entirely. We remain cautiously optimistic, positioning portfolios carefully while poising for all opportunities that emerge.

Strategy Activity

Please see below for a summary of the trades we executed over the week through Thursday and our current tactical strategy allocations.

Dividend Income

AIQ Tactical Defensive Growth

AIQ Tactical Multi-Asset Income

No trades

AIQ Tactical High Income

Third-Quarter Webinar Replay

If you were unable to join our third-quarter webinar, Building Wealth Through Economic Turning Points, please click here to watch the replay!

Our Latest Market Outlook Video

In our latest video, Chief Investment Officer Tim Clift shares his expert perspective on the bull market, the future of fixed income, private market stocks and much more. Click here to watch now.