Jerome Powell warns stocks are ‘fairly highly valued’—what he means

[ad_1]

It’s been a terrific year for stocks so far. Despite some turbulence in the spring, the S&P 500, a measure of the broad U.S. stock market, is up more than 12% since the year began.

It’s a runup that has some market watchers wondering if investors have gotten out over their skis. In a speech in Rhode Island on Tuesday, Federal Reserve Chairman Jerome Powell fielded a question about how central bankers factor market prices into their decision making.

“We do look at overall financial conditions, and we ask ourselves whether our policies are affecting financial conditions in a way that is what we’re trying to achieve,” Powell said. “But you’re right, by many measures, for example, equity prices are fairly highly valued.”

Powell doesn’t just mean that stock prices are flirting with record highs. He means that stocks are looking overvalued — a sentiment that sent markets slightly lower.

“Probably the oldest tenet in investing is ‘buy low, sell high,'” Sam Stovall, chief investment strategist at CFRA, previously told CNBC Make It. While a long-term, diversified approach is typically recommended for everyday investors, the professionals are also attuned to the market’s cycles. They typically hope to buy when stocks are cheap and sell when they’re expensive.

It’s impossible to know which “measures” Powell is looking at. But often, when experts value stocks, they generally they look at price-to-earnings ratio. The popular valuation metric, also known as P/E, currently shows that stocks are, indeed, pricey. In fact, the S&P 500 currently trades at a 41% premium to its 20-year average, according to CFRA.

How P/E ratios work

To determine how attractively a stock is priced, Wall Street analysts don’t just look at the share price. Instead, they compare the price with one of the company’s underlying fundamentals, such as sales, cash flow or, most popularly, earnings.

Because investors reap the rewards of corporate profitability over time, they’re willing to pay more than the company brings in, in order to own a piece of it, in the form of stock. This amount is expressed by dividing the share price by the company’s earnings per share to get the price-to-earnings ratio.

If a stock sells for $10 and is projected to realize $2 in earnings per share over the next 12 months, it has a P/E of 5.

In a vacuum, that doesn’t mean much. But it’s a great way to compare one investment to another, or to compare an asset or an index to a historical average.

Looking at the S&P 500, stocks in the index currently trade at 23.8 times their projected earnings over the next 12 months. Over the past two decades, the index has an average P/E of 16.8. That means stocks are about 41% more expensive now than they have been over the past 20 years.

Applying the same logic, you could say that the S&P’s P/E high ratio means that U.S. stocks are more expensive than international firms, whose S&P indexes trade at a P/E of 15.7. You could also say that a small-company index, such as the S&P SmallCap 600, with its P/E of 17.1, trades at a discount to the large-company S&P 500.

None of that is to say that the S&P will go down tomorrow or that foreign stocks or smaller-company stocks will outperform over the next year. Historically, the market operates in cycles, with different asset classes taking turns in the proverbial lead.

Over the long run, the fast-growing names that lead the market lose their luster, and prices come down, while under-loved, “value” stocks return to the fore, Charles Rotblut, vice president of the American Association of Individual Investors, previously told CNBC Make It.

He doesn’t advise making wholesale changes to your portfolio based on short-term conditions in the market, but says it’s worth paying attention to where things stand in a cyclical market and making sure you’re adequately diversified.

“We know over the long term, there are periods where growth outperforms and there’s periods where value outperforms, so we do see that pendulum swinging back and forth,” Rotblut says. “I don’t think this time is any different.”

Want to be your own boss? Sign up for Smarter by CNBC Make It’s new online course, How To Start A Business: For First-Time Founders. Find step-by-step guidance for launching your first business, from testing your idea to growing your revenue. Sign up today with coupon code EARLYBIRD for an introductory discount of 30% off the regular course price of $127 (plus tax). Offer valid September 16 through September 30, 2025.