Proceed with caution

Stock prices look frothy. If corporate profits get wobbly, look out below.

Stock prices have gone gangbusters. The S&P 500 index of big American companies has risen 40% in the last two years. But corporate profits haven’t kept up. In fact, they’ve fallen. The index’s earnings per share has dropped 2% in that time. That bifurcation has some investors worried that the market is in a bubble. So, have investors overvalued the stockmarket? Yes. Stocks look expensive here, and investors should proceed with caution.

On a discounted cash flow basis, the market looks pricey. 𝑉𝑎𝑙𝑢𝑎𝑏𝑙’s model, which uses analysts’ earnings estimates for each company in the index, values the S&P 500 at about 4,900. That’s 15% above the price. Although it’s not a perfect estimate, it suggests investors are giddy. And it’s the most expensive stocks have been since the 2021 market boom. 𝑉𝑎𝑙𝑢𝑎𝑏𝑙’s model estimated that traders had overvalued the market by 15% in September 2021. Subsequently, the market corrected and fell 18% in the following year.

This overvaluation comes despite…