Bond giant Pimco warns that equity valuations are historically high.
The current S&P 500 CAPE ratio is in the 94th percentile of all-time.
Equity risk premium is also around as low as it was before the 1987 crash and the dot-com bust.
It’s been a tranquil few weeks for financial markets as investors wait to see how the US economy holds up under President Donald Trump’s tariff regime.
But things could change quickly, Pimco warned in a note on Tuesday.
By several measures, stock valuations are sitting at levels historically seen before big corrections, the $2 trillion asset manager said in a note written by global economic advisor Richard Clarida, chief investment officer of Fixed Income Andrew Balls, and group chief investment officer Dan Ivascyn.
The first gauge they cited is the Shiller cyclically-adjusted price-to-earnings ratio, which compares the current S&P 500 price to a 10-year moving average of its earnings. Its current level of around 36x earnings is in the all-time 94th percentile.
The second measure is the equity risk premium, or the projected assumed returns of stocks over 10-year Treasurys based on current valuations. Sitting near zero, the ERP has only been this low 10% of the time. When it’s been this low in the past, significant stock-market declines have followed — see the 1987 crash and the dot-com bust in 2000.
“A mean reversion to a higher equity risk premium typically involves a bond rally, an equity sell-off, or both,” the note said. “The same chart shows two prior times when the premium was zero or negative: in 1987 and in 1996—2001.”
It continued: “Following the zero equity risk premium in September 1987, the stock market declined by almost 25%, while 30-year real bond yields fell by 80 basis points (bps). In December 1999, the equity risk premium reached its minimum level during the chart period, preceding an equity drawdown of almost 40% that ended in February 2003. In that same time, 30-year real bond yields fell by about 200 bps.”
High stock valuations make it likely that fixed-income assets outperform stocks in the years ahead, the note said. With yields high and rate cuts probably on the way, investors can clip an attractive coupon and have a good chance of seeing appreciation in the price of bonds down the road.
Valuations themselves are poor predictors of near-term stock price action, but if a negative catalyst comes along — a bad jobs report or rising inflation — high valuations leave the market vulnerable to more pronounced downside.
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