Is the stock market expensive?
I was meeting with a prospective client recently and we were talking about whether now is a good time to invest or not. In his opinion, it felt like the markets are at a precarious level and over-priced. When I hear this sort of sentiment it is often coming from a gut feeling so I pressed to hear more about this feeling. And like most people, the feeling was simply based on the fact that the market is currently reaching record highs. There’s something psychological about this connection between new highs and feeling expensive. It got me thinking about how we look at valuing the market and I thought it might be helpful to share with you.
For purposes of this conversation, I will use the S&P 500 index as a representation of the U.S. stock market. The S&P 500 index was created by Standard & Poors to represents the market value of the 500 largest companies in America.* As of this writing, its level stood at 4,236 per share – very near the all-time high.
Most people look at that value and immediately think it’s expensive because it’s a big number. It is a big number, and it is the biggest it has been in their lives. When I was born in 1973 the S&P 500 index stood at 118. By this logic, the market is certainly more expensive today than it was back then. But that logic would be wrong because we are only looking at a nominal value.
Looking at the face value of the index by itself only describes if the number has increased or decreased over time. Aside from this limited observation, the number does not tell us whether it is good or bad, over-priced, or currently on sale.
We have to compare it to something relevant in order for it to make sense. Like most things in life, a relative comparison is needed to improve our comprehension. And that is where corporate earnings come in.
Earnings are the profits that a company makes after deducting expenses from income. Earnings are the most fundamental variable that determine the worth of a business. Corporate earnings that are growing leads to a more valuable company.
If you were to add up all of the earnings for the companies that make up the S&P 500 index you would have the number you need to make your comparison with. To keep things manageable, earnings are typically reported on a per share of stock basis. There are companies that track this sort of thing and Wall Street analysts are currently estimating corporate earnings for the 2021 calendar year to be about $200 per share.
Comparing the current level of 4,236 to expected earnings of $200/share gives us 22 (4,236/200). This formula is referred to the Price to Earnings ratio, or P/E ratio. On the surface, this tells us that the S&P 500 index is currently trading for 22 times expected earnings. We still don’t know if this is good or bad, it’s just math at this point.
A logical approach would be to compare this number with history. What has the historical P/E ratio been? Is 22 higher, lower, or in line with the historical average? Are there factors that influence the historical average (hint: changes in interest rates)? Most notably, are Wall Street analysts correct with their estimates of corporate profits?
- Current Reading: 22
- 5 Year Average: 18
- 10 Year Average: 16
Based on historical values, the current level of the stock market might be high. But I think we have to question Wall Street Analyst estimates before making that conclusion. The following graphic depicts the current estimate for what corporate earnings will be over the course of the next several quarters.
We just ended reporting for the first quarter of 2021. That is the grey bar in the middle of the chart where earnings were $49/share. Estimates for the rest of this year were originally created during the second half of last year when there was more uncertainty about how the economy would play out. And analysts are generally slow to raise their estimates following a recession, doing so only during quarterly reporting periods.
Ask yourself, does it make sense for future earnings to be lower than the most recent quarter if the economy is continuing to improve? Probably not. I think the current estimates are low. Maybe by as much as 10% – 15%. If that is the case, then earnings estimates should be closer to $210 to $215 and that would result in a P/E ratio between 19 and 20. Much closer in historical levels.
Having used today’s stock market characteristics as an example, I hope you can see that the question of whether a market is expensive or not is nuanced. The question requires considering many different factors rather than simply the face value of its level. Corporate earnings estimates are one factor, but there are others too. For example, structurally low interest rates will lead to higher P/E ratios. Maybe I’ll follow up on that topic with a future article.
For now, let me leave you with some take-aways:
- The face value of the stock market index is just a number. It has very limited usefulness by itself.
- We must compare the level with something important. Most of the time that would mean comparing it with expected corporate earnings.
- The estimate for earnings must be fair and reasonable. Estimating profits six months to a year in advance is as much art as it is science.
- As much as we’d like to think the market is efficient, it is not perfectly efficient. Analysts being slow to raise their estimates is an example of inefficiency.
- Are there other factors that justify a P/E ratio being higher than its historical average? Maybe lower interest rates justify higher values.
Let me know what you think about this type of content. Did you find it useful? Are there other topics like this one that you would like to hear more about?
Oh, by the way, we recently conducted another webinar update on the state of the Covid economy. If you did not get a chance to catch it, you can watch it here.
* The S&P 500 index produced by Standard and Poors is an unmanaged index. Individuals cannot directly invest in unmanaged indexes.