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June 2020 / INVESTMENT INSIGHTS

Have Stocks Become Too Expensive?

Despite dire forecasts, equity valuations remain reasonable

Key Insights

  • After the sharp rally in equity markets amid dire economic data, investors may be questioning whether stocks have become too expensive.
  • While caution is warranted, we believe that equity valuations remain reasonable relative to bonds.


Stocks have rebounded sharply from March lows despite the alarming backdrop of plummeting earnings expectations and staggering unemployment numbers. This apparent contradiction is prompting many investors to question whether stocks have become too expensive, given dire economic forecasts.

Relative to the alternative, which for most investors is bonds, we do not think that equities are too expensive. To compare the valuations of stocks and bonds, equity valuations can be converted into earnings yields by inverting price/earnings (P/E) ratios.

A comparison of the S&P 500 forward earnings yield to BBB rated corporate bond yields from December 2016 to May 2020 shows that, while the yield on stocks has become less attractive on an absolute basis, it remains well above the bond yield—even though earnings projections have fallen considerably over recent months. This signifies that investors still appear to be compensated for the additional risk of owning stocks instead of bonds. Further, an analysis of the equity yield premium since 1997 shows that, relative to history, stocks are priced quite reasonably versus bonds.

We have recently moderated our equity position in our asset allocation portfolios as valuations have become less attractive after the recent market rebound. In our view, caution is also warranted given the heightened level of uncertainty and the depth of the near-term economic shock we are facing.

However, we continue to believe that, despite the bleak economic outlook, equity valuations appear attractive relative to bonds. As a result, our asset allocation portfolios remain overweight to stocks.
 

Comparing Stocks vs. Bonds

Investors still appear to be compensated for owning stocks.

Comparing Stocks vs. Bonds

Past performance is not a reliable indicator of future performance.

Source: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. 
BBB Corporate Bond Yield is based on the BofAML U.S. corporate bond universe. S&P 500 forward earnings yield is IBES earnings estimates over the next 12 months. Earnings Yield= Earnings/Current Price. 3-Month U.S. Treasury yield is based on the benchmark 3-month U.S. Treasury Bill.
Equity yield premium compares the forward earnings yields for stocks on the S&P 500 versus the  yields to maturity of U.S. Treasuries and BBB bonds.

IMPORTANT INFORMATION

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

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