How Overpriced Is the Market?

Covering tech stocks as we do in the Gilder Technology Report, we naturally ask that question every time our subscribers get a little bit richer!

Our answer. Not as overpriced as some long-term historical data and long-time pundits suggest.

To assess the valuation of the stock market over the past 50 years or so, it is imperative to note two great events. The Reagan tax cuts and the Trump tax cuts.

Reagan first.

How bad it was.

You can’t really have capitalism if capital is persecuted as it was in the pre-Reagan decades.

Suppose you had invested $100 in the S&P 500 in 1960. By 1980, these would have been your results.

• Your original $100 would have grown to $491, before taxes or inflation.
• That’s an annualized return of 7.9%, 2.6 points lower than the historic S&P average of 10.5%.
• With inflation raging however, your $491 stash would be worth a mere $177, and your CPI adjusted return would be a mere 2.74%. ¹
• Even with the cap gains rate recently reduced to 28%, after paying your $110 tax bill on your nominal gain of $391, your real gain of $77 becomes a loss of $33.
• You stayed faithfully invested in the market for 21 years and lost 33% of your money.

Now comes Reagan.

In 1981, you invested $100 in the S&P 500. We’ll assume you hold it through 2002, so as to include the Tech Wreck and not artificially boost returns.

• By 2002, your $100 has become $1,289 for a nominal annual return of 12.3%, almost 17% above the historic S&P average and 56% better than 1960-1980.
• With inflation subdued, even in real terms, you’ve made $551, or 8.89% per year, 244% better than your 2.74% real return for 1960-1980.

Meanwhile, from December 1983 (by which time the Reagan tax cuts were fully phased in) to December 2003, the S&P 500 index rose from 519 to 1,904, or 270%. That seems, as Lord Keynes would say, vaguely right rather than precisely wrong.

Despite an annoying increase in the top personal tax rate, the Reagan revolution is not only still in place on net, but it has gotten stronger. Clinton cut the cap gains rate to 20%. George W. Bush, “the younger,” cut taxes on dividends to 15%. Now at 20%, it is still lower than in Reagan’s day.

Then in 2017 came the Trump corporate tax rate cuts from a 35% maximum to 21%. So now let’s look at corporate earnings for the S&P 500.

Once again, we start when the Reagan tax cuts fully kick in, launching 41 years of very strong results. With all that growth it’s hard to relate specific events to the graph. Nevertheless, there is a decided acceleration of growth starting with the Trump corporate tax rate cut. From May 2017 through May 2024 (last numbers we could easily get), corporate earnings grew at a compound annual growth rate of almost 11.5%, compared to roughly 5.5% from 1983 to 2017.

Source: Macrotrends, by permission

Why use earnings? If we are measuring valuation, wouldn’t it make more sense to compare PEs, or price-to-earnings ratios over time to see how much people are paying for earnings. Yes, except that stock prices build in expectations of growth. When earnings grow quickly, prices follow suit.

The chart below shows the PE of the S&P 500 over time. We are certainly near historic highs. But notice two things. First, in the wake of the Reagan tax cuts, we see a durable secular rise in PE. That makes sense as investors captured a greater portion of earnings via after tax, after inflation returns.

After the Trump tax cuts, there is another rise, but even today at circa 29 (not shown on graph which ends in early 2024), we are not much above the Reagan level of PEs in the mid-20s.

So, pricey? Yes. Crazy, no. Investors should be cautious but not in a panic.

Source: Macrotrends, by permission