Stretched valuations

The message of tight spreads and high equity multiples

August was an encouraging month for risk assets, the catalyst being Jerome Powell’s speech at Jackson Hole, with more than half of the 7% monthly return of the Russell 2000 Index coming on August 22, the day he delivered his 20-minute keynote speech.

Credit markets were boosted by the enthusiasm for potential future rate cuts as well as very muted supply in the second half of the month, a traditionally slow period ahead of the Labour Day holiday. Despite the strong risk tone in late August, the ICE BofA US High Yield Index saw spreads close the month at 284 basis points (bps) Govt OAS, just 3bp lower than where they started the month. The HFRI Credit Index returned 1.2% in August, bringing year-to-date returns to 6.2%.

In the weeks that followed Powell’s speech, the market appeared to interpret weak employment data as positive, given that it increases the probability of further interest rate cuts by the Federal Reserve. The “bad news is good” dynamic only holds if data indicate a slowing economy not a recession, so sustainably bad news would likely cause market dynamics to shift.

Despite the market performing well, we are seeing some increasing evidence of stress on the margins as many weaker credits have come under pressure, the distress ratio in the high yield market increased in August for the first time since April. Broadly syndicated loans had the highest proportion of “blow-ups,” or drops of 10 points or more in over a year, in August, according to Bank of America data.¹

In contrast to the buoyant risk appetite in markets over the summer, there has been mounting evidence of weakening economic fundamentals in the labour market in both Canada and the United States. Inflation does not appear to be moderating further and could see a delayed increase from tariffs in the coming months following the end of the de minimis exception in late August. There is a real risk of stagflation.

Spreads are tight, and equity multiples are high. Cameron Crise, who writes the “Macro Man” column at Bloomberg, tracks what he calls the “Hopes and Dreams ratio,” which is the amount of a stock or market’s valuation that is not explained by book value and the NPV of the next three years of earnings. In August, the Hopes and Dreams ratio for the S&P 500 hit 67.8%, its highest level since April 2000, which was one month following the peak of the dot-com bubble. Importantly, the ratio had first hit those levels in April 1999, so its valuation alone doesn’t indicate that a selloff is imminent. While a new 25-year high was reached in August, the ratio was very close to this level as far back as November 2024 following Trump’s election.

While valuations tell us little about where the market might go over the short term, over the long run, valuation can be a dependable predictor of forward returns. The S&P 500 forward P/E ratio has hung around 23x in recent weeks and for much of the past 10 months, as noted in the chart below.

Justin Jacobsen, CFA, is the Portfolio Manager of the Pender Alternative Absolute Return Fund at PenderFund Capital Management. Excerpted and updated from the Pender Alternative Absolute Return Fund Manager’s Commentary, August 2025. Used with permission.

Notes

1. Bank of America Global Research and ICE Data Indices LLC

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