- The stock market may be expensive by traditional measures, but that doesn't mean investors should avoid stocks.
- Bank of America said comparing current valuations to those of the past is comparing apples to oranges.
- "The S&P 500 has half the leverage, is higher quality and has lower earnings volatility than previous decades," BofA said.
The stock market "is wildly expensive" compared to the past, but that doesn't mean investors should avoid stocks, according to a Wednesday note from Bank of America Savita Subramanian.
The American stock strategist said that although the S&P 500 is "statistically expensive in 19 out of 20 metrics and is trading at a 95th percentile price relative to trailing earnings based on data going back to 1900," doesn't mean stock prices can't continue to rise from here, and for one good reason. .
In particular, Subramanian took issue with compare current stock market valuations with those of the past, when the composition of the S&P 500 looked very different.
"I think the one bearish argument that I often hear that I want to try to debunk is simply the idea that the market is too expensive," Subramanian told CNBC on Wednesday. "People will take the current S&P and compare it to 10 years ago, 20 years ago, 30 years ago, 40 years ago. I don't think that makes sense because the market today is a very different animal."
The S&P 500 currently trades at a 12-month trailing price-to-earnings ratio of 24.5 times, well above its 10-year average of 21.1 times. Meanwhile, the S&P 500's forward price-to-earnings ratio is 20.4 times, more than one standard deviation above its 30-year average of 16.6 times.
But perhaps the S&P 500 should trade at a higher valuation than it did 30 years ago considering that the underlying companies within the S&P 500 are much more profitable today than in the past, Subramanian suggests.
"The S&P 500 is half as leveraged, higher quality, and has lower earnings volatility than previous decades. The index gradually moved from 70% asset-intensive manufacturing, financial, and real estate companies in 1980 to 50% asset-light technology and healthcare. ," She explained.
And that different makeup is reflected in the S&P 500's profit margins, which have doubled from less than 6% in the 1980s to nearly 12%.
"We're in a different game here, so you can't just look at the S&P today and take that P/E and compare it over time," Subramanian told CNBC.
Ultimately, despite historically high market valuations, stock prices are likely to remain on an upward trend as long as corporate profits do not plummet from their current levels.
"This good realistic scenario suggests a fair value for the S&P 500 of ~5,500," Subramanian said, representing a 9% upside potential from current levels.
