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Let me get my bias out of the way. As a lifelong Yankee fan, I was not exactly thrilled that Juan Soto signed with the crosstown Mets instead of remaining with the pennant-winning Yanks. But then my anger waned when I thought about the terms of the deal: $765 million over 15 years! Far be it for me to question the valuation skills of the Mets’ owner, Point 72’s Steve Cohen, but I do believe that the bidding war and eventual outcome reflect the mentality of the stock market.
All investments, whether buying equities or signing a free agent athlete, require a careful estimate about present value. In the case of a star baseball player, where contracts are fully guaranteed, the team must decide how much that player’s production might fall off as he ages. Soto is only 26, quite young for a star free agent, but that meant that he could demand an even longer contract than usual. As a result, his contract is now the largest in sports history. It also means that after his $75 million signing bonus, the Mets will be committed to paying at least[i] $46 million a year to an aging player who is unlikely to remain one of the best in the sport for that long.
Now ask yourself whether we might be seeing something similar in the stock market. Investors are willing to pay ever increasing prices for their favorite stocks, making an implicit bet that today’s best performers will remain among the best in their league for the foreseeable future. Remember that, at least in theory, the current price of a stock reflects the present value of its earnings or cash flows or future dividends, depending upon which valuation model you choose. But at the margin, the market sets the price, and the premia that both stock investors and team owners (who are often one and the same) ebbs and flows along with supply and demand.
A key method that stock investors use to measure that demand is the P/E ratio. The company does its thing, making money (hopefully) and developing a predictable earnings stream. That’s the “E” in the equation. The “P” is much more of a matter of psychology. It’s how much investors are willing to pay for those earnings. And currently investors are willing to pay quite a bit for them. The trailing P/E for the S&P 500 (SPX) is currently about 27, and on a forward basis it is about 25.5[ii]. Those are lofty by historical standards.
In the past 30 years, prevailing P/E’s have been exceeded only twice over an extended period. Both P/E measures reached nearly 30 at the end of 1999, just as the dotcom bubble was nearing its peak. That Yet the current P/E reached 33 in May 2021 while the forward P/E peaked at 31.5 a quarter prior. In the former case, the market turned lower just about three months later; in the latter it was about nine months. As with most fundamental valuation measures, they are not reliable short-term pricing tools, even though they tend to correct in the longer-term.
You’ve probably heard the term “multiple expansion”, which refers to how much of the market’s rise can be attributed to rising P/E’s. The current rally has relied heavily on multiple expansion. When it began in October 2022, SPX was just under 3600, current P/E was about 17 and forward P/E was about 16. Thus, SPX has risen just under 70% since then, while the P/E’s have risen about 59%. Thus, the vast majority of the increased level of SPX can be explained simply by an increase in how much investors are willing to pay for current and/or future earnings, far outweighing the rise in those earnings.
Can this persist for a while longer? Sure. Frankly there is no limit to how much investors are willing to pay for a given earnings stream. In a momentum-driven environment, when many traders are motivated by the prevailing trends and therefore the likelihood that prices will go up largely because they have already been doing so, this behavior can continue relatively unabated. That is, until or unless something changes.
I hope for Met fans that Juan Soto’s performance continues at his recent pace. (OK, not really). But it was clear that his price was set by the market, since it was reported that the Mets’ bid was not much higher than the Yankees’. Investors need to hope the same for the stock market. But while a baseball contract lacks liquidity, stocks do not. Team owners can only acquire insurance for a player’s health, not his performance. Investors can consider insuring their peformance as well.
Related: Is the Market Rally Nearing Its End?
[i] Soto can opt out of the contract after 5 years, which he could do if he believes his value has increased further. The Mets can retain him by committing another $4 million/year for the remainder of the deal, which would push him up to $50mm/yr. This means that the Mets also gave Soto an implicit option within the deal. For simplicity, we’ll leave that aside when we consider the deal’s valuation.
[ii] We are using Bloomberg data for consistency’s sake, particularly regarding forward P/E’s