Is the Stock Market Expensive Right Now?

The stock market started 2024 with a blistering rally, with the Morningstar US Market Index up 7.8% so far and roughly 26% higher than its lows in October. But the relentless pace of gains has some watchers worried about soaring valuations on stock prices and frothy trading.

“When prices go up that much, earnings rarely go up the same amount,” says Ed Clissold, chief US strategist for Ned Davis Research Group. “So valuations will increase.” Investors worry that overvalued stocks signal an unhealthy market that’s vulnerable to a sudden pullback.

That concern is only amplified by the high prices associated with some of the “Magnificent Seven” megacap tech stocks, which have an outsized impact on the performance of the market. On the other hand, strong earnings could mean stocks stay expensive for good reason. “As long as earnings growth keeps improving, investors may be willing to stomach higher valuations,” Clissold explains.

So are stocks too expensive, too cheap, or just right? Here’s what investors need to know.

How to Measure Stock Market Value

There are various methods analysts use to measure whether individual stocks or the overall market are overvalued, undervalued, or fairly valued. Most rely on comparing a stock or index’s fundamentals with its share price to get a sense of whether investors are paying more or less than what it’s worth.

One of the most common ways to determine a stock’s valuation is the price/earnings ratio, which is calculated by dividing its price by its earnings. Using past earnings gives market watchers a better look at a stock’s historical context, while using estimates of future (or forward) is a better way to think about how it will perform in the future.

As of the end of February, the US Market Index carried a trailing P/E ratio of 24.01. Over the past decade, that ratio climbed as high as 28.61 in March 2021 and dropped as low as 16.72 in December 2018.

When it comes to valuations, “it’s all relative,” says Adam Turnquist, chief technical strategist at LPL Financial. “A ratio means nothing without relative context.” In general, he thinks current P/E ratios show the stock market is relatively expensive.

On a trailing basis, the S&P 500 Index is trading at a P/E ratio of 24.77. That’s well above its longer-term average of about 19 but close to its five-year average of 24.46, according to data from FactSet. The ratio climbed to nearly 30 in the spring of 2021, however. “These [valuations] are high,” Clissold says, “but not historically so.”

Stock analysts also use other metrics to value stocks, like the price-to-book ratio or the equity risk premium. All these models aim to paint a picture of how a stock or index’s fundamentals compare with what investors are willing to pay for it.

Morningstar’s Price/Fair Value Ratio Shows Stocks as Fairly Valued

Morningstar analysts measure valuations by comparing a stock’s current price to our estimate of its fair value. A ratio higher than 1.0 indicates a stock is overvalued, or expensive, while a ratio under 1.0 indicates that it’s undervalued, or cheap.

Right now, the P/FV ratio of the US stock market is 1.02. This is significantly higher than last fall, when the ratio dropped below 0.8, but lower than in 2021, when the ratio climbed above 1.1 as stocks struggled to break out of a bear market.

Morningstar chief US market strategist Dave Sekera writes that with stocks fully valued, “the market is starting to feel stretched.” He recommends that investors look to contrarian strategies in undervalued sectors like real estate, utilities, and energy rather than stick to the technology and communications stocks that have propelled the market until now. “Once a trend has become fully valued, an investor should be willing to buck that trend and begin to tilt one’s portfolio to where valuations are more appealing,” he writes.

Market Conditions Support Higher Stock Valuations

Stocks that are “expensive” by some measures aren’t necessarily bad news, however. Turnquist points to several factors that are helping support elevated valuations: Inflation is falling, the US economy is holding up well, and the Federal Reserve is on the cusp of loosening monetary policy. Interest rates are expected to stabilize. We’re also exiting an earnings recession, and companies largely have strong balance sheets and have reported strong earnings. Margins are expanding, and tailwinds related to artificial…