AI Is Just One Reason Stocks Are Pricey. They’re Still a Buy.

ITrivariate Research President Adam Parker notes that investors should use more than just valuation metrics to pick stocks. (TIMOTHY A. CLARY / AFP / Getty Images)

In the age of inflation, even stocks are pricey—but that’s no reason not to buy them.

As the bull market continues to chug ahead, not much has been able to slow it down, not even multiple wars, tariffs, and a spending bill that piles on more government debt. However one consistent knock against stocks has been that they are quite expensive, and the numbers are certainly high. The S&P 500 changes hands for more than 22 times forward earnings, and it’s not just all the tech sector, which has a forward price-to-earnings ratio of above 30: The consumer discretionary, staples, and industrial sectors are all above 22 times.

That said, expensive is often in the eye of the beholder. In a world on the cusp of great productivity and profit gains from the artificial-intelligence revolution, it could be worth paying up for that growth, goes many bulls’ arguments.

Trivariate Research President Adam Parker argues that AI is a major reason why high valuations shouldn’t deter investors—but it’s far from the only one.

He notes that AI is playing an undeniably important role: Not only are there obvious winners like semiconductor firms such as Nvidia , but all the potential beneficiaries of the technology—companies with low margins and lots of employees that may be able to ultimately use AI to be more profitable with a lower head count. That could be anything from a retailer such as Costco Wholesale to a drug distributor such as McKesson . Even companies that seemingly wouldn’t see much or any impact at all from AI can still benefit, he argues, given that investors will pay up for business models that can’t be disrupted by AI, such as waste disposal.

Yet that’s far from the whole picture, Parker argues. Consider that today (unlike in decades past) most quantitative models are valuation-neutral, meaning quant shops “can be long and short stocks in each valuation decile, and be completely and purposely indifferent.”

Retail investors too, he notes, are less interested in valuation, because they’ve learned in recent years that “expensive growth stocks keep working.”

That brings him to his fourth point: Searching for bargains has rarely paid off in recent years. “The performance of the cheapest quintile of stocks on price-to-forward earnings is inferior to those in the most expensive quintile over the last decade,” he writes.

In fact, snapping up cheap stocks even before a recession doesn’t necessarily work. This strategy assumes that companies that are already discounting a recession would also bounce back more quickly. However Parker found that in fact, stocks with the most multiple contraction ahead of recessions still performed the worst—as it turns out, the market was right to discount their shares because their fundamentals did take a big hit during downturns.

Finally, he highlights the fact that valuations and margins are linked; margins are high at the moment, so betting on out-of-favor stocks is a bit like bracing for margin declines. He expects just the opposite will happen to the average company moving forward, given a relatively strong economic backdrop, a weaker dollar, and ongoing pricing power.

That said, Parker doesn’t endorse ignoring valuation entirely. Extremely expensive stocks are usually best avoided, and the same can also be said of value traps. In addition, valuations can fluctuate depending on the environment, most recently seen during 2022, when rapid interest-rate increases crimped growth stocks’ multiples.

Nonetheless, he concludes that “using valuation to pick stocks can almost be thought of as arrogant or incompetent in many cases at this point.”

In some cases, a splurge just makes sense.

Write to Teresa Rivas at teresa.rivas@barrons.com