S&P 500 faces valuation test as stocks open lower, yields climb

The S&P 500 opened lower Monday as rising Treasury yields and elevated oil prices tested a bull market that has pushed valuations to levels unseen since the dot-com era.

"The combination of higher yields and stubbornly high oil prices is squeezing equity risk premiums in a way we haven't seen in years," said Michael Wilson, chief equity strategist at Morgan Stanley.

The S&P 500's Shiller cyclically adjusted price-to-earnings ratio stood at 42.84 as of early June, roughly 146% above its 155-year average of 17.4, according to data compiled by economist Robert Shiller and backtested to January 1871. Only the dot-com bubble peak of 44.19 in December 1999 has exceeded the current level. The 10-year Treasury yield pushed higher Monday, while crude oil held recent gains, compounding pressure on equity valuations.

The last five instances of the CAPE ratio topping 30 during a continuous bull market all preceded significant drawdowns. The Great Depression erased 89% of the Dow Jones Industrial Average's value from its 1929 peak. The dot-com bust wiped 49% from the S&P 500 and 78% from the Nasdaq Composite. More recently, the 2008 financial crisis and the 2020 pandemic selloff each followed elevated valuation readings.

History favors the patient

Despite the ominous valuation signal, long-term data offers a counterpoint. Bespoke Investment Group data shows the average S&P 500 bear market since 1929 has lasted 286 calendar days, or about 9.5 months. Bull markets have persisted for 1,023 calendar days on average — roughly 3.6 times longer. Crestmont Research's analysis of rolling 20-year total returns for the S&P 500 dating to 1900 found that all 107 rolling periods generated positive annualized returns, regardless of wars, recessions or depressions.

The current bull market, which began after the October 2022 lows, has already exceeded the average bear market duration by a wide margin. But the valuation overhang means the path forward may depend on whether earnings growth can catch up to prices.

Sector rotation and breadth

Technology and consumer discretionary names led the decline Monday as the yield-sensitive growth trade came under pressure. Energy stocks outperformed, tracking crude's advance, while utilities and real estate — sectors most sensitive to rising rates — lagged. The advance-decline line on the New York Stock Exchange tilted negative, with declining issues outpacing advancers by a roughly 2-to-1 ratio in early trading.

The VIX, Wall Street's fear gauge, edged higher, reflecting increased demand for portfolio protection. Trading volume was above the 20-day average as investors repositioned ahead of a busy week of corporate earnings and the Federal Reserve's July policy meeting.

What comes next

The Fed's rate decision on July 30 looms as the next major catalyst. Markets are pricing in a hold, but the trajectory of inflation and the labor market will shape the outlook for the second half of the year. If yields continue to climb and oil holds above recent levels, the valuation compression that has been building for months could accelerate, turning a gradual reset into a sharper correction.

For now, the bull market's durability rests on a simple question: can earnings grow fast enough to justify a CAPE ratio that has only been higher once in 155 years?

This article is for informational purposes only and does not constitute investment advice.