It’s important to start by discussing why valuation measures matter to long-term investors. Simply put, valuations are the best tools that investors have to gauge the attractiveness of the stock market over years and decades. This contrasts with much shorter time frames during which global headlines, industry news, and company-specific events can dominate market movements. These concerns eventually settle and fade, leaving only traces of their impacts on asset prices, underlying fundamentals, or both.

Unlike stock prices on their own, valuations don’t just tell you how much something costs, but what you get for your money in terms of earnings, book value, cash flow, dividends, and other measures. After all, holding shares of a company means you are entitled to a portion of its profitability, so paying an appropriate price can improve the odds of future growth. Valuations are correlated with long-term portfolio returns for this reason – i.e., buying when the market is cheap can improve the chances of success, and buying when the market is relatively expensive can reduce future returns.

What do valuations tell us today? On the surface, broad stock market valuations are above both their recent lows and historic averages. The price-to-earnings ratio for the S&P 500 (based on next-twelve-month earnings) is 19.1x, well above the average of 15.6x since the mid-1980s. This metric only briefly fell to 15.3x during last year’s bear market crash before rebounding immediately. These numbers are highly dependent on the market and economic cycle and can therefore fluctuate over time. For example, the average over the past decade has been considerably higher at 17.6x, making it more difficult to interpret these valuation metrics.

Interest rates also impact stock prices directly through financial markets and investor preferences. When rates are higher, bonds become more attractive relative to stocks since they can generate more income. The resulting headwind on stocks can be interpreted as investors shifting their portfolios toward bonds, or equivalently that stock prices should adjust so that their “yields” rise to new levels.

The first chart highlights this relationship by focusing on the earnings yield of the S&P 500, which is just the inverse of the P/E ratio. This measure tells us how much in corporate earnings an investor is “yielding” for every dollar they invest, allowing us to think of stocks in a bond-like way. Specifically, the S&P 500 has an earnings yield of 5.2% compared to 10-year Treasury bonds yielding around 4%. The gap between these two measures – a gauge of the relative attractiveness of stocks over bonds, has fallen as interest rates have risen.

On the surface, these measures suggest the market is no longer cheap, which is to be expected after this year’s significant rallies. However, there are big caveats to the preceding discussion. One reason this may be harder to interpret today is that the market’s earnings yield has worsened not only because stock prices have risen, but also because earnings expectations have been flat.