You're Misreading Valuations | Jim Paulsen on Why the Mean Reversion You Expect May Never Come

Key Concepts

• Market Valuations: The assessment of a company's or market's worth, often using metrics like Price-to-Earnings (P/E) ratios.
• CAPE Ratio (Shiller P/E): A valuation metric that uses inflation-adjusted earnings over a 10-year period.
• Risk-Return Frontier: A concept in portfolio theory illustrating the highest expected return for a given level of risk, or the lowest risk for a given level of expected return.
• Monetary Stimulus: Actions taken by central banks to increase the money supply and lower interest rates to stimulate economic activity.
• Fiscal Stimulus: Government spending or tax cuts aimed at boosting economic activity.
• Recession Frequency: The historical rate at which economic downturns occur.
• Sentiment: The overall attitude or feeling of investors towards the market, often measured by indices like the Fear and Greed Index.
• Broadening Market Participation: An increase in the number of stocks or sectors contributing to market gains, as opposed to gains being concentrated in a few.
• New Era vs. Old Era Sectors: A distinction between technology and communication sectors (new era) and more traditional sectors (old era) in the stock market.

Market Valuations: A Shifting Landscape

The discussion centers on a significant shift in market valuation ranges, moving beyond historical norms. This change is not expected to revert soon, suggesting a fundamental alteration in how market values are determined. The analysis utilizes multiple charts and indicators to provide a comprehensive view, moving beyond single metrics.

Current Market Developments and Investor Focus

Despite recent market highs, several factors are drawing attention:

• Pervasive Fear and Pessimism: A significant positive force for the current bull market is the persistent "wall of worry." This is evidenced by:

  • Consumer Confidence: Remaining at record lows, measured by the University of Michigan Sentiment index.
  • CNN Fear and Greed Index: Currently at 42, indicating fear, below the median of 50%.
  • Federal Reserve Action: The Fed's decision to lower rates by 25 basis points, despite market highs, suggests underlying concern.
  • Gold's Performance: Exploding to new record highs, signaling a "fear asset" demand.
  • Money Market Funds: Holding $7 trillion, a significant portion of disposable personal income, nearing record highs.
  • Notable Warnings: Statements from figures like Jamie Dimon (cockroaches in the financial system), Bill Gross (concerns about 4% tenure), and Andrew Rash (comparisons to 1929) highlight widespread apprehension.
  • Geopolitical and Trade Tensions: Ongoing events like government shutdowns, trade tariffs, and military actions contribute to uncertainty.
  • Dot-Com Comparison: The persistent comparison of the current market to the dot-com bubble, with its subsequent collapse, fuels investor anxiety.

• Upcoming Economic Data Releases: The re-release of economic reports after a period of government shutdown is anticipated to create volatility. Investors are advised to monitor non-governmental releases like ADP, Conference Board, University of Michigan, and regional Fed reports.

• Market Momentum Indicators:

  • Cyclical Sectors: The relative underperformance of cyclical sectors (materials, industrials, consumer discretionary, financials) by 4.2% since the government shutdown's end suggests underlying economic weakness.
  • Inflation-Sensitive Equities: An ETF tracking inflation-sensitive equities (BINF) has declined 2.5% on a relative basis, correlating with CPI movements and indicating weakness.

• Broadening Market Participation: Despite media focus on AI and tech, there's evidence of broader market strength:

  • Micros, Smalls, IPOs, Low Quality: These segments are performing better.
  • International Stocks: Showing improved performance.
  • Defensive Sectors: Experiencing declines on a relative basis.
  • Underlying Market Reaction: The market appears to be reacting positively to easing monetary conditions, with increasing money supply, potential end of QE, falling fund rates, declining bond yields, and a weakening dollar.

The Role and Limitations of Market Valuation

The discussion highlights a shift in how market valuation should be approached, moving away from its traditional role as a precise timing tool.

• Historical Context: The speaker, with 43 years of experience in value investing, notes a significant departure from his early days when only single-digit P/E multiples were considered.
• Divorce from Traditional Valuation: The speaker has "divorced himself" from relying heavily on traditional valuation metrics due to their perceived unreliability in the current environment. He believes this has led to bad investment decisions and excessive conservatism.
• Focus on Environment and Sentiment: The emphasis is shifting towards understanding the market environment (hostile vs. supportive) and investor sentiment rather than solely on whether the market is "fairly valued."
• Sentiment as a Risk Indicator: High sentiment (exuberance) often correlates with high valuations and can signal future risk, while pessimism can accompany low valuations. However, bear markets can occur even with low valuations if sentiment becomes excessively negative.
• Uncertainty in Valuation: The speaker admits to "flying like everyone else" and not having a definitive answer on how to best use valuation metrics currently.

The Shifting Valuation Range: Evidence and Analysis

Several charts illustrate the dramatic change in historical valuation ranges.

• CAPE Ratio (Shiller P/E):

  • Historical Norm (1870s-1990s): The CAPE ratio historically stayed within a range of approximately 6-7 to 21. The 90th, 50th, and 10th percentiles from 1900 to 1994 remained relatively stable.
  • Post-1994 Shift: Since 1994, the CAPE ratio has consistently been at or above the 90th percentile of its historical range for most of the time. This indicates a sustained period of higher valuations, not just a single bubble event like the dot-com era.
  • Broken Scale: The historical range has become a "broken scale" for judging high and low valuations.
  • Drifting Northward: The problem is exacerbated by the fact that this new valuation range is not static but continues to drift upward, making it difficult to establish a new "normal."
  • Impact on Forecasts: This shift invalidates many long-term forecasts based on mean reversion to historical averages, leading to consistently wrong predictions of poor returns.

• Broad-Based Valuation Increase (Kenneth French Data):

  • Deciles of PE Ratios (1950-2024): Analysis of all NYSE and NASDAQ stocks by PE deciles reveals a broad-based increase in valuations across most segments.
  • Comparison to 1960s Peak: Even the 70th percentile of stocks today are valued below the previous valuation peak in the late 1960s. Most percentiles, including the 90th, have remained at or above their 1990 levels.
  • Concentration vs. Breadth: This is not solely a phenomenon of a few tech stocks; the valuation increase is widespread across the market.
  • Log Scale Interpretation: The use of a log scale on charts means vertical distances represent equal percentage changes, highlighting that the spread between top and bottom deciles has remained relatively consistent, but the entire spectrum has shifted upwards.
  • Pre- vs. Post-1994 PE Ranges: Comparing PE ranges from 1951-1994 (where top decile was 31-44%) to 1994-2024 (where valuations are consistently above the 60th percentile) demonstrates a significant upshift in PE valuations across the entire US stock market.

• S&P 500 Trailing 12-Month P/E with Rolling Averages:

  • Historical Median (Pre-1990s): The median P/E ratio for the S&P 500 historically hovered around 14.
  • Post-1990s Drift: Since the mid-1990s, the median P/E has chronically drifted higher, reaching nearly 20 times earnings in the last 30 years. This current average valuation is equivalent to the upper end of the historical valuation range.
  • Unsettled Range: The continuous upward drift makes it difficult to use valuation measures reliably until a normalized range is established.

Drivers of Higher Valuations

Several factors are identified as contributing to the sustained higher valuation ranges.

• Reduced Recession Frequency:

  • Historical Data (1880-Present): Recessions were significantly more frequent historically, occurring roughly once every two to three years.
  • Post-WWII Decline: Since World War II, and particularly in the last 25 years, recession frequency has dropped dramatically to around 10%. The last 15 years have seen only one short, one-month recession in 2020, caused by an exogenous health crisis.
  • Impact on Risk Premium: Reduced recession risk makes earnings more predictable and reliable, allowing investors to afford higher multiples. This is analogous to how growth stocks command higher multiples than cyclical stocks due to their more stable earnings.
  • Reduced Bear Market Risk: Lower recession frequency correlates with fewer bear markets, further supporting higher valuations.
  • Potential for Higher Returns: The chart showing trailing 25-year stock returns versus recession frequency suggests that as recession risk decreases, stock returns tend to increase. A continued low recession risk could support higher annualized returns.

• Reasons for Reduced Recession Frequency:

  • Federal Reserve and Monetary Policy: The introduction of the Federal Reserve in 1913 and the subsequent evolution of monetary policy (moving away from Hoover's fiscal tightening during the Depression) have played a role in moderating the business cycle.
  • Innovation Cycles: Significant and rapid innovation cycles can create demand for new products that drive growth, overriding cyclical impulses for periods.
  • Conservative Balance Sheets: Since the 2008 financial crisis, households and corporations have maintained lower debt-to-income ratios and higher liquidity, reducing vulnerabilities that typically trigger recessions. This "best behavior" has made recessions harder to initiate.

• Increased Liquidity:

  • Household and Corporate Cash to GDP: The ratio of liquid asset holdings by households and corporations to GDP has risen significantly since the early 1990s, reaching over 75%.
  • Impact on Financial Assets: This excess cash seeks investment, flowing into equity markets and contributing to higher valuations. Greater market liquidity also reduces risk.

• Profit Productivity:

  • Real Corporate Profit per Job (1940-Present): Real corporate profit per job remained stagnant from 1940 to the early 1990s but has tripled since then.
  • Correlation with CAPE Ratio: This surge in profit productivity is strongly correlated with the rise in the CAPE ratio, suggesting that increased profitability per employee justifies higher stock valuations.
  • Technology and Innovation: This productivity gain is attributed to technology, innovation, and the combination of labor with capital, with AI potentially further fueling this trend.

• Forward P/E Multiple as a Sentiment Indicator:

  • Shift in Valuation Focus: The forward P/E multiple has become a popular valuation metric, replacing trailing P/E.
  • Sentiment vs. Valuation: The speaker argues that the forward P/E is more a measure of sentiment than true valuation.
  • Limited Predictive Power: Analysis shows that forward returns are not significantly different across various quintiles of forward P/E ratios, suggesting it offers little predictive edge.
  • Correlation with Bullishness: The forward P/E growth rate closely tracks consumer sentiment (bulls less bears), indicating that rising forward multiples are driven by investor optimism rather than fundamental valuation changes.
  • Sentiment and Risk/Reward: While sentiment is not a bad indicator of future risk and reward (high sentiment often leads to lower future returns), the forward P/E should not be mistaken for an independent valuation metric.

Sectoral Valuations and Market Concentration

The analysis delves into the valuation of different market segments.

• New Era vs. Old Era Sectors:

  • Technology and Communications: These "new era" sectors exhibit significantly higher trailing P/E multiples (around 36-37 times earnings) compared to historical norms.
  • Rest of the S&P 500: The remaining nine sectors of the S&P 500 are not excessively valued, with many being cheaper than at the peak of the 2021 bull market.
  • Earnings Availability: A key difference from the dot-com era is that current "new era" companies have earnings, unlike many in the 2000 bubble.

• Mid and Small Cap Valuations:

  • Reasonably Priced: The S&P Midcap and S&P Small Cap indices are trading at reasonable absolute P/E ratios, not exhibiting excessive valuations.

• Growth vs. Value and Other Indices:

  • Growth Index: Driven by tech and communications, the growth index shows high valuations.
  • Low Volatility, Equal Weighted, Value Indices: These indices do not show excessive valuations, indicating significant relative cheapness in parts of the market.

• Industry Group Analysis:

  • Relative PE: Currently, over 70% of the 72 industry groups within the S&P 500 are trading at below-average relative P/E ratios. This highlights the concentration of the bull market in specific areas and suggests considerable relative cheapness elsewhere.

Risk-Return Frontiers and Policy Regimes

The discussion introduces the concept of risk-return frontiers to analyze investment portfolios under different economic policy regimes.

• Risk-Return Frontier Construction: The red line represents the risk-return frontier for portfolios of stocks and bonds, illustrating the trade-off between risk (standard deviation) and return.

  • 100% Bonds: Low return (6%), low risk (11% std dev).
  • 100% Stocks: High return (12%), high risk (14% std dev).
  • 60/40 Portfolio: Offers a balance with 9% risk and 9% returns.

• Policy Regimes: Four frontiers are analyzed based on economic policy:

  • Red: High fiscal stimulus, low monetary stimulus (current bull market environment).
  • Blue: Low fiscal stimulus, high monetary stimulus.
  • Green: High fiscal stimulus, high monetary stimulus.
  • Yellow: Low fiscal stimulus, low monetary stimulus.

• Shifting to a "Green" Environment: The speaker suggests a potential shift from the "red" frontier to the "green" frontier, characterized by both high fiscal and high monetary stimulus. This transition is expected to be a boon for investors, potentially leading to higher returns for both stocks and bonds.

Final Takeaways and Conclusion

• Not a Dot-Com Redux: The current market is not a repeat of the dot-com bubble. Today's companies are profitable, more innovative, and the tech sector's size relative to the economy is significantly larger (20% of GDP vs. 2% in dot-com era).
• Valuation Discrepancy: While tech valuations are high, they are not at the same irrational levels as in 2000. The tech sector's larger weighting in the market means its performance has a greater impact, but the risk of a complete collapse is perceived as lower.
• Underperformance Risk: The primary risk for tech is underperformance rather than a collapse.
• Broader Market Opportunities: Significant relative cheapness exists in many other sectors and industries, offering opportunities for investors.
• Bond Market Dynamics: The current bond market environment, with relatively low yields and the perception of potential rate increases, differs significantly from the 1980s, impacting the stock-bond risk-reward dynamic.
• Toggle Switch for Stock vs. Bond Returns: Historically, when bond yields fall below 4%, the excess returns of stocks over a 60/40 portfolio significantly increase. The market is currently on the cusp of this "toggle switch."
• Future Outlook: The speaker anticipates a potential shift towards a "green" policy regime (high fiscal and monetary stimulus), which could be highly beneficial for investors in the latter half of the current cycle.

The overarching theme is that market valuations have fundamentally changed, driven by factors like reduced recession risk, increased liquidity, and enhanced profit productivity. While traditional valuation metrics are less reliable, understanding the underlying economic and policy drivers is crucial for navigating the current investment landscape.