The Data Is in Plain Sight

Most investors are having a hard time reconciling what is happening in the world with a market that continues to climb higher. With each uptick, more voices warn of an impending decline. Valuations are near historic extremes, and elevated prices often come at the cost of short to mid-term performance. Of course, no one can predict exactly when returns will turn negative, and it is exciting to watch prices climb. But beneath the excitement, a question lingers: how concerned should we really be?

Consumers in Good Shape

There are compelling reasons why today’s economic environment should not be compared to 2008. First, household net worth has reached an all-time high, currently standing at $176 trillion, a dramatic rise from $68 trillion in 2007, just before the recession. Lower-income consumers are struggling with inflation; however, investors with assets (who tend to spend more) are in better shape than in 2007.

Another metric is owners’ equity as a percentage of household real estate (the value of your house minus the mortgage), at 73% is now at its highest level since 1960. This figure has climbed from 46% in 2010, reflecting a strong foundation of homeowner equity.

Another indicator of consumer health is the liabilities-to-assets ratio. Today, household debt represents just 11% of total assets, compared to 19% in 2009. This decline underscores a more resilient consumer balance sheet.

The explanation is straightforward: most homeowners locked in ultra-low mortgage rates during the extended period of historically low interest rates. As a result, they’re unlikely to refinance or take on new debt unless they have a strong motivation to do so. This dynamic has allowed asset values to grow faster than debt levels.

While public debt remains a separate and complex issue, the good news is clear: the consumer is not under stress. So, consumers are relatively healthy, but what does this mean for the market?

But Some Valuations Still Look Stretched

Before diving into valuations, it’s worth remembering that valuation metrics, while useful, are notoriously poor at predicting short-term market performance.

One of the most widely used valuation tools is the price-to-earnings (P/E) ratio. Currently, the S&P 500 trades at approximately 27 times earnings, well above its long-term average of 16. However, this headline figure masks significant concentration. The seven largest companies, which now account for roughly 30% of the index’s market cap, trade at a lofty P/E of 42. In contrast, the equal-weighted S&P 500, where each company carries the same weight, has a P/E of 18. The top seven represent just 1.5% of that index. This divergence echoes the conditions of the year 2000, when anything internet-related was on fire. Then tech stocks saw steep declines even as the broader market posted gains. Please remember there is no guarantee the same outcome will happen again.

Another lens for valuation is free cash flow yield (free cash flow divided by market capitalization). The top seven companies generate about $395 billion in free cash flow against a combined market value of $20 trillion, yielding just 1.9%. Meanwhile, companies ranked 51 to 75 in the S&P 500 produced $174 billion in free cash flow on $4.2 trillion of market value, resulting in a much healthier 4.1% yield. For context, the 10-year Treasury currently yields 4.15%. While Treasuries offer fixed returns, corporate earnings have the potential to grow over time. Historically, free cash flow yields above Treasury rates have signaled attractive equity valuations, especially considering earnings do grow over time.

There is a Wall Street adage that says markets climb a wall of worry. We have plenty to worry about, and markets are climbing. You can either invest to earn 1.9% or 4.1%. Both numbers have reasons as to why one may be better than the other. Knowing what those reasons are goes a long way toward avoiding a big surprise in the future.

Observations on the Market No. 411