Bank of America: S&P 500's Extremely High Valuations Are the "New Normal'

The extremely high valuations of S&P 500 stocks are the "new normal" because the internal structure of the market is very different from what it was a few decades ago, says Savita Subramanian, an equity strategist at Bank of America (BofA), Business Insider reports.

"The S&P 500 is a different animal than in previous cycles," Subramanian wrote in a note published late last week.

According to the strategist, of the twenty measures of stock valuation he tracks, 19 are at extreme levels. For example, the price-to-earnings ratio of 25.3 is 70% above the 125-year average of about 15. But the high valuations are justified and will likely remain so, says Subramanian, who points out that there is less leverage in the market today, the composition of the index is of higher quality, and the structure of companies' assets is different from that of the past.

"After the Covid pandemic, companies have adapted to higher input costs by investing in efficiency; improvements are ongoing," Subramanian said.

In his view, technological improvements facilitated by AI and automation, along with more efficient labor costs, should lead to a productivity boom not seen in decades.

"This is something similar to what we saw in the early 1980s, and today's equity risk premium is close to the average levels of the 1980s/90s and nowhere near the negative levels we saw in 2000," Subramanian said.

The strategist also sees the service orientation of S&P 500 companies with positive eyes. While in 1980 the index was 70% exposed to the manufacturing economy, today the S&P 500 has a 50% exposure to so-called "asset-light companies" (note: companies that have few physical assets, focus on leveraging external resources, partnerships or technology, which allows them to have lower capital expenditures and greater flexibility), specialized in innovation.

These types of companies should facilitate a productivity boom, which will ultimately help generate more stable earnings that are less prone to cyclical ups and downs. "Replacing people with processes improves earnings per share (EPS) visibility," Subramanian said, adding that increased profit visibility justifies higher valuations.

Subramanian has a target price of 6,666 for the S&P 500, which represents a potential upside of 14% from late last week, according to Business Insider.