Has the Market Correction Restored Fair Valuations?

With U.S. stocks now in correction territory, is the market valuation finally reasonable? Troy Ludtka, Senior U.S. Economist at Sumitomo Mitsui Banking Corporation Securities America, analyzed two uncommon indicators to assess how expensive the stock market has become.

P/E Ratio vs. Core Inflation: A Broken Historical Correlation

The first indicator compares the price-to-earnings (P/E) ratio with core inflation, a metric Ludtka describes as one of our preferred yet simple macro frameworks.

Historically, these two indicators have maintained a strong negative correlation. However, since the COVID-19 pandemic, this relationship has completely broken down, to an unprecedented extent.

Typically, high inflation depresses P/E ratios because rising inflation leads to higher interest rates, which increase discount rates and lower stock valuations. Additionally, investors tend to shift toward low-risk assets like bonds, further suppressing P/E ratios. Conversely, low inflation fosters lower interest rates, making investors willing to pay higher multiples for stocks, pushing P/E ratios higher Our key concern is how this fundamental relationship will be restored, given that both inflation and earnings expectations remain elevated, Ludtka noted.

The most favorable scenario, which is currently unfolding, is for inflation to gradually decline toward the 2% target while corporate earnings remain strong. This scenario would be reflected in a leftward shift in the correlation chart.

However, if this trend continues, the U.S. market will soon enter a territory last seen during the dot-com bubble! In other words, if inflation declines without a corresponding drop in earnings multiples, history suggests we are entering a period of irrational exuberance, Ludtka warned.

If P/E ratios decline, Ludtka believes the U.S. economy could experience negative wealth effects and potential recession risks, given the high household exposure to equities.

S&P 500 vs. M2 Money Supply: A Valuation Warning

The second indicator compares the S&P 500 Index to the broad M2 money supply, which also suggests equity valuations are dangerously high.

According to Ludtka, the latest data shows this ratio has reached its highest level since Q4 2000, marking a historical extreme.

The S&P 500-to-M2 ratio is a key metric for assessing market valuation. A higher ratio suggests the market is overvalued and riskier, while a lower ratio implies more attractive investment opportunities and lower equity valuations.

U.S. equities are overvalued and excessively held by investors, Ludtka stated. If uncertainty rises and expectations become overly optimistic, this combination could be disruptive.

This doesn't mean stocks can't perform well in the short term—because they certainly can—but economic theory suggests long-term returns may be at risk, Ludtka concluded.