- The Federal Reserve’s recent interest rate cut and expectations of resilient economic growth have driven stocks to new all-time highs, raising concerns about potential overvaluation.
- While stock valuations appear above average based on metrics like price-to-earnings and free cash flow yield, factors such as high profitability, strong earnings growth, and low interest rates support the current valuations, particularly in the technology sector.
- Despite the optimism, risks remain, including the potential for disappointing future cash flows and the uncertainties surrounding the post-COVID economic cycle, suggesting investors should maintain appropriate asset allocation and risk tolerance.
Stocks have continued their rally to new highs after the Federal Reserve’s rate cut. But with lofty valuations, are stocks overpriced?
The Recent Stock Rally
The Federal Reserve recently cut rates more than expected, boosting optimism about avoiding a recession. This news ignited a further leg of the stock rally, sending stocks to new highs.
The S&P 500 is up 22% year-to-date, while tech stocks have soared nearly 30%. Stocks like Microsoft, Meta, Amazon, Apple, Nvidia, Alphabet, and Tesla – known as the Magnificent 7 – outperformed the S&P 500 this week and are nearing their July highs.
Valuing the Stock Market
With stocks at record highs, are they overvalued? Valuing stocks involves estimating future cash flows and discounting them to the present. But human emotion also impacts prices.
Based on the forward price-to-earnings ratio, stocks don’t look cheap historically. However, the P/E ratio tends to correlate with return on equity. And ROE remains above average, arguing for a higher P/E.
Cash Flow Analysis
Warren Buffett 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 is a good measure of money accruing to shareholders.
The free cash flow yield, which compares free cash flow to price, indicates stocks aren’t cheap but have been more expensive. This assumes static cash flow, so it also signals confidence cash flow will grow.
Tech stocks have an even lower cash flow yield, reflecting optimism about their future and superior fundamentals.
Profitability and Growth
Like ROE, profit margins remain high versus history. Tech profit margins are nearly double the overall market, explaining the premium valuation.
While cash flow yield is backward-looking, S&P 500 free cash flow per share has grown 5.1% annually over 5 years. Tech has grown even faster at 8.6%, reinforcing its dominance.
The Role of Interest Rates
To value future cash flows, they must be discounted to the present using an interest rate. With the Fed cutting rates, longer-term yields are also expected to decline.
Recession Risk
Cyclical stocks outperforming defensive stocks indicates lowered recession fears. Consensus S&P 500 earnings estimates also point to continued growth.
But soft landings aren’t guaranteed. And with high profit margins and valuations, there’s less room for error.
Conclusion
Valuation isn’t straightforward. If profits and cash flow continue growing, stocks may be underpriced. Leading tech companies have strong competitive advantages supporting growth.
However, above-average valuations and margins limit the margin for error. Risks are higher when optimism prevails. Long-term investors should focus on asset allocation and risk tolerance, not overvaluation. Defensive stocks provide balance in case of volatility. But abandoning top tech companies without contrary evidence is unwise.
