- The S&P 500’s valuation may sit near historic highs but history suggests the market can continue climbing, James Paulsen, chief investment strategist at The Leuthold Group, said.
- The index’s current price-to-earnings multiple “appears extreme,” but mostly because stock fundamentals were slammed by the coronavirus pandemic, according to Paulsen.
- As profits rebound, higher earnings will serve as a larger divisor in the P/E ratio and pull the S&P 500 to a healthier valuation, the strategist added.
- Paulsen expects the S&P 500 to climb roughly 11%, to 4,100, by the end of 2021.
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Investors concerned that the S&P 500 is too highly valued to climb any higher are forgetting a key driver for new gains, James Paulsen, chief investment strategist at The Leuthold Group, said.
The benchmark’s trailing 12-month price-to-earnings multiple currently sits at around 28.7, an elevated level that’s nearly as high as during the dot-com boom. The metric has led some investors to grow increasingly worried that the market’s recent rally has little room left to run.
Yet the ratio was similarly elevated in 1992, 2002, and at the end of 2009. Traders should focus more on the ratio’s components than its current reading, Paulsen said in a note.
“Like the start of the last three bull markets, the S&P 500’s current P/E multiple appears extreme, mostly because fundamentals were hit hard by the pandemic crisis,” he added.
Specifically, corporate profits remain far below pre-pandemic levels despite stocks sitting near record highs. The S&P 500’s currently depressed earnings-per-share level plays a significant role in elevating its P/E, as the earnings part of the ratio serves as a smaller divisor.
The highly valued markets of the past three expansions were characterized by earnings climbing higher than stock prices, and it’s likely that the next bull market will show a similar trend, Paulsen said. The benchmark’s trailing earnings per share stands at $127.91, and analysts expect it to climb to $172.23 by the end of 2021. The projected 35% climb “leaves plenty of room” for the market to rally higher while also improving its valuation, the strategist added.
Paulsen personally expects the index to climb roughly 11%, to 4,100, over the next year. Its P/E multiple will fall to 22 from 29, and earnings per share will surge to $185.
A sudden valuation shock could arrive in the next few years if inflation climbs faster than expected, Paulsen added. But if the next bull market mimics the previous three, “the path to more sustainable valuations may be far less dramatic and much more profitable than feared.”
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