Traders work on the floor at the New York Stock Exchange (NYSE) in New York, U.S., January 10, 2020.
Brendan McDermid | Reuters
What investors are willing to pay for stocks relative to their long-term earnings growth expectations is at an all-time high, according to Bank of America.
The price-earnings to growth ratio, commonly called the PEG ratio, sits at 1.8, its highest level since the firm started tracking in 1986.
The general rule of thumb is a PEG ratio over one means a stock or a market is overvalued. PEG is a stock’s price-to-earnings ratio divided by the expected long-term growth rate in earnings per share.
The idea is to show whether stocks are cheap or expensive relative to how much earnings are expected to grow over time. This ratio shows either stock prices need to fall or earnings need to grow much faster than expected.
The S&P 500 has rallied nearly 9% since November, shrugging off tensions with the Middle East and tariffs on Chinese goods.
“The S&P 500 is running on fumes,” Bank of America equity and quant strategist Savita Subramanian said in a note to clients Thursday.
“We have pulled forward some of the gains from later this year, and could see some multiple compression,” Subramanian added.
Look to Amazon and energy stocks for why there has been a pullback in earnings growth outlooks for the year, Bank of America said.
Last quarter, Amazon’s stock got clobbered when its earnings fell short of expectations. The e-commerce giant missed on its cloud business’ sales, which could be a drag on future earnings as it has provided the bulk of Amazon’s operating income for the past four years. Plus energy stocks, the worst performing sector of 2019, are struggling to grow profits as high operating costs and lower oil prices continue to eat into revenue.
Other metrics are also near extremes, including the most common way to value stocks.
Price-to-earnings ratio at 18-year high
The current price-to-earnings ratio is at 18.4 times, hitting a level the ratio hasn’t seen since 2002, according to Bank of America. This means that investors are willing to pay more for each dollar of earnings than they have in nearly two decades. This too signals that investors are expecting a bigger-than-expected jump in earnings that may not come.
The S&P 500 is less than 1% away from Bank of America’s 2020 year-end target of 3,300.
Bank of America is not the only Wall Street firm worried about stocks being overvalued. Goldman Sachs pointed out to clients last week that the stock market relative to the size of the economy, or the U.S. equity market cap-to-GDP ratio is at an all-time high. Plus, the cyclically adjusted price-to-earnings ratio, created by Nobel Prize winner Robert Shiller, is near the highest since 2000 dot-com bubble.
— with reporting from CNBC’s Nate Rattner, Crystal Mercedes and Michael Bloom.