Valuation Distortions

The Real Estate Espresso Podcast

Valuation Distortions

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Welcome to the Real Estate Espresso Podcast: your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce.

On today’s show, we’re discussing distorted valuations. When considering risk, I’m seeing what can only be described as an atmospheric inversion in today’s markets. Wall Street touched a new record high on Thursday as the S&P 500 surpassed its February 19th close of $6,144. It’s continuing a rally worth nearly $10 trillion.

Against all odds, markets seem to be dismissing concerns over war in the Middle East and the security of oil. President Trump has declared a ceasefire and magically, a war that’s been sporadically active for 75 years is over. The index gained almost 1%, propelled by the tech giants and a bank stocks rally after a veteran analyst declared it’s game on as long as the economy avoids recession.

I’m going to compare the risk-free yield on US Treasuries as a baseline benchmark for today’s show. In some respects, every other investment could be compared against this benchmark.

I’ll avoid the debate as to whether the US will default on its debt in the next ten years or not.

For the purpose of this discussion, let’s assume that the US will meet its debt obligations, even if this means increasing the annual deficit and global debt.

We know this will eventually break down but, for now, let’s take the US Treasury as foundation.

The reason for this is, because the reference currency for all these investments is the US dollar. If the US dollar’s stability is in question, then the value of all the dollar-denominated investments could also be questioned. This includes numerous big names in the market like Nvidia, Amazon, Walmart, United Airlines and so on.

Therefore, let’s label the risk-free rate of return as the yield on the US 10-year Treasury. Today, the market opened at 4.25%; pretty much in sync with the Federal funds rate. Whether you invest in a 30-day T-bill or a 10-year bond, your risk-free rate of return for today sits at 4.25%.

The argument here is that an investment offering a lower yield suggests it’s a better investment than the risk-free rate of return. So, let’s examine the price-to-earnings multiple of the S&P 500.

If you calculate, the S&P 500 currently operates at 28 times, trailing the 12-month earnings. Calculating the reciprocal, you get a potential yield —assuming all the companies in the S&P 500 paid out all their earnings to shareholders. This results in a possible yield of 3.57%, which is less than the 10-year Treasury yield.

The market implies that the 500 companies comprising the S&P 500 have yielded a 3.57% return when viewed retrospectively. Somehow, this is a better gamble than the risk-free rate of return at 4.25%.

I know what you’re thinking. You can’t just look at the trailing price-to-earnings ratio. Instead, you should be looking at the forward price-to-earnings ratio over the next year. That’s a projection of what earnings the 500 companies listed on the S&P 500 will achieve.

The market analysts who assess all these forecasts predict significant earnings growth. The forward P/E for the S&P 500 is currently a lower 22x earnings. By the way, that’s still in the stratosphere compared to history.

Doing the same calculations again, we get a 4.5% yield from all of the companies on the S&P 500. This again assumes that they distribute all of their net income to investors, which, of course, they don’t.

So, according to the market, the equity market is a safer bet than the US Treasuries risk-free rate of return. An investment in the S&P 500 is as good as cash. It’s also as good as holding a 10-year US government bond.

But let’s revisit the price-to-earnings ratio. Is it possible that the US could enter a recession in the coming years? If that were to happen, the forecast earnings increase is assumed in the forward projection price-to-earnings ratio would no longer be accurate.

If earnings stay flat or fall, then the P/E ratio would be at least as high as the current 28 times earnings or even higher if earnings collapse.

Now, US President Bennet has argued that tariffs will not be inflationary and that the cost of tariffs will be absorbed by companies and not passed on to consumers. So, if the government is extracting tariff revenue from the supply chain and consumers won’t pay the tariffs, then the funds can only come from one place — corporate earnings.

So can someone explain to me, using any kind of math that adds up, how we’ll see rising corporate earnings continue into next year? Especially, given these valuations we’re seeing in the S&P 500 index.

Some will argue that the valuation is driven by technology, AI, and yes, NVidia holds a disproportionate share of this value increase in the stock index. But we also have AMD, IBM, Huawei, and Google all developing their chips to compete with NVidia. NVidia’s early market dominance is currently being challenged.

We may not see the repercussions of this within the next 90 days or even the next 180 days. However, NVidia will lose some market share because their existing clients do not want to pay NVidia’s inflated prices. That’s merely a fact.

We also know that Nvidia is going to compete with its existing clients by entering the data center business. However, the business landscape is filled with companies that have died competing with their customers. So, can someone please rationalize these S&P 500 valuations because I don’t understand them.

As you contemplate this, have a fantastic rest of your day. Go and make some incredible things happen, and we will chat again tomorrow.