So, are stocks cheap or expensive?
Morning Observers,
If you read analyst commentary about today's stock prices, you'll come across two opposite conclusions at the same time.
Some analysts say stocks are cheaper than they have been, on average, over the past five years. Others say stocks are the most expensive they've been since the dot-com bust.
Both groups are technically right. So which one is actually right?
There are hundreds of ways to estimate the fair value of stocks, but they can be broken down into three schools of thought: backward-looking, forward-looking, and comparative.
One of the most popular backward-looking measures is the Shiller P/E. It compares stock prices with their inflation-adjusted earnings over the past 10 years.
The biggest strength of this approach is that it effectively ignores temporary spikes in nominal earnings, like the one we have right now because of AI.
That's the measure that's often implied in those scary headlines. It's currently around 40x, its highest reading in history except for the very top of the dot-com bubble.
The problem is that these temporary spikes can last five years or even longer, which can leave you underinvested during some of the biggest growth cycles.
For example, the Shiller P/E reached its highest level in more than 60 years in 1995. But the bubble popped only five years later, after the S&P 500 had doubled.
On the other side of the spectrum, we have forward-looking measures like forward P/E. It measures stock prices against what analysts think companies will earn over the next 12 months.
And it's currently cheaper than its average over the past five years.
The good thing about forward-looking measures is that stocks are valued based on what they are expected to earn in the near term. That means you won't miss most of the growth cycle. But there are two risks with these estimates.
First, analysts always overshoot their earnings estimates before downturns. Second, business cycles are temporary. And stock valuations have always reverted to the mean over a long enough timeline.
That can, and probably will, happen with AI, too. The catch is that nobody knows whether we are in "1995" or "1999" in the AI cycle.
The third way to know whether stocks are fairly valued is to compare them with the second most popular asset class: bonds.
If you flip the P/E ratio upside down, you get a lesser-known measure called the earnings yield, which tells you how much stocks are "yielding" at today's valuations.
Then you compare it with bond yields and get the spread, or the premium you are supposedly being rewarded with for taking the extra risk.
Around 2022, that spread turned negative for the first time in more than 20 years, meaning stocks are technically earning less than bonds, even though they are riskier.
This is a useful warning sign, but it doesn't tell us why the spread turned negative.
Stocks may be overpriced because investors have pushed valuations too far. Or bonds may simply be unusually cheap because of inflation and political uncertainty.
Or perhaps the market is predicting that the economy will absorb higher inflation, pushing nominal earnings higher while bonds lose value, which is what happened after 2022.
So, who's right? All three schools of thought can be right, just at different points in the cycle.
- Dan Runkevicius, Editor
📱 Apple's record iPhone prices
Apple unveiled its first foldable iPhone on Wednesday, and it won't come cheap. The iPhone Duo starts at $1,999 and tops out at $3,199 with additional storage. Apple also broke with tradition by raising prices on older models instead of discounting them, including increasing the price of the iPhone 17 from $799 to $899.
💸 $6 billion Treasury buyback fails to calm the bond market
Treasury Secretary Scott Bessent surprised markets on Wednesday by announcing a $6 billion buyback of longer-dated Treasurys, up from the $4 billion minimum announced last month. But the larger buyback did little to calm the bond market, with the 10-year Treasury yield climbing as high as 4.85% and the 30-year yield spiking to 5.31%, matching its previous multi-decade high.
📉 Stocks fall for a third straight day
U.S. stocks declined for a third consecutive session on Wednesday, with the S&P 500 falling 0.5%, the Dow losing 0.8%, and the Nasdaq dropping 0.6%. Rising oil prices and elevated Treasury yields added to concerns about inflation, leaving the S&P 500 roughly 2% below its August record high as investors await Friday's CPI report.
⚠️ RBC warns the pullback may have further to go
RBC Capital Markets strategist Lori Calvasina sees a growing risk that the S&P 500 will fall another 5% to 10% as inflation, higher interest rates, and the U.S. midterm elections weigh on the market. However, her longer-term outlook remains bullish, with RBC maintaining a 12-month target of 8,150 for the index.
📊 Friday's CPI report could settle the rate-hike debate
Friday's Consumer Price Index report could seal the deal on next week's rate decision. Brown Brothers Harriman said a hot reading would "all but seal" a September hike, which is in line with an earlier call from Apollo's Torsten Slok, who already views a rate hike as the most likely outcome. The Fed meets on Sept. 15-16.
Bitcoin and gold are correlated again — opportunity or trap?
Bitcoin spent much of the past year looking more like a tech stock than "digital gold." Now it's started moving hand in hand with gold again.
The shift comes as the Treasury expands its buybacks of longer-dated bonds, including a $6 billion operation announced on Wednesday. And the timing is hard to ignore.
The digital gold trade is back
Bitcoin's 90-day correlation with gold has climbed above 0.50, near its highest level since the pandemic stimulus boom in 2020, according to Bitwise Asset Management.
The correlation has more than doubled since the start of the year.
At the same time, Bitcoin's correlation with the Nasdaq-100 has fallen to a one-year low, suggesting the cryptocurrency is beginning to break away from the tech trade.
This makes the recent rally above $80,000 look different from previous run-ups. Investors appear to be treating Bitcoin more like an alternative to the dollar than a speculative asset.
Gold could spoil the party
But trading like gold comes with a trade-off.
Gold peaked in January and has struggled to reclaim the top because higher oil prices are reviving inflation concerns and pushing markets toward another Fed rate hike.
In fact, gold slipped again this week as traders raised the odds of a September hike to more than 60%.
JPMorgan still sees gold reaching $6,000 by year-end, but says the path increasingly depends on Fed policy and a resolution to the Iran war.
If higher rates and rising real yields begin to outweigh concerns about currency debasement, Bitcoin's correlation with gold could become a liability.
So far, that doesn't seem to be happening, or at least not to the extent it historically has.
Despite rising real yields, gold has still managed to hold its ground, thanks to unusually strong demand from central banks. That creates a rate asymmetry that cushions gold investors.
📌 Bottom line: Bitcoin is finally trading more like the hard asset its supporters have long claimed it is. But behaving like gold also exposes it to the downside of the yellow metal."