In April, the S&P 500 hit a new high, crossing 4,000 for the first time. Milestones like this come with the inevitable questions about valuation. Are stocks too expensive? To guard against overpaying, investors can turn to historical averages or rules of thumb for points of reference. But we risk ignoring current conditions that impact valuations and drawing the wrong conclusion. With that in mind, what factors should you consider today?
Earnings are still strong
Companies are priced based on their earnings, for which investors pay a multiple reflected in a valuation ratio called price over earnings (P/E). Using the S&P 500, the historical average P/E ratio is 15-16x. Based on that comparison, the S&P 500 offered at 21x earnings could be seen as expensive. But calling the market overvalued is not the same as saying the same for every single stock. The average P/E represents a range of companies, in different industries, with dissimilar prospects and diverse growth rates. For example, the forward P/E for Growth stocks is 27x and the forward P/E for Value stocks is 17x. We have already seen a rotation boosting the P/Es of relatively cheap value stocks at the expense of relatively expensive growth stocks. Value should continue to outperform Growth for a while.
P/E ratios are typically calculated using forward or expected earnings, calculated by Wall Street analysts with input from company management. Analysts and management receive favor when actual earnings exceed their estimates, so both parties have incentives to underestimate future earnings. As it stands, first quarter earnings reports were strong and we believe full year earnings for 2021 are generally underestimated.
If future earnings turn out to be higher than expected, it would mean your P/E today was too high. As the economy reopens, earnings are accelerating. In addition, productivity gains are allowing companies to maintain their profit margins, a positive indicator in the fact of possibly rising inflation.
Relying only on average P/E ratios hides what is going on underneath.
Low Interest Rates mean higher valuations
When interest rates decline, that can affect stock prices in two ways. The first is due to the discount rates applied to value future business earnings. As the discount rate moves lower, company earnings become more valuable. The second relates to stocks and bonds competing for our capital. When rates are low, stocks and their higher dividend yields look more attractive, supporting valuations. Rates have been historically low, and overnight rates were pressed back to zero in 2020, which means higher stock values.
Remember too that historical P/E averages are looking back decades and stem from economic environments where higher average interest were the norm. The higher stock prices we have seen since 2008 reflect a willingness to paying a higher P/E in a much lower interest rate environment.
Ignoring the current low rate environment can lead to an incorrect assessment of stock valuations.
Market highs are a weak predictor
Every time markets hit new highs, investors ask whether they can go higher. So far, the answer has always been yes. A report from UBS showed, based on data going back to 1960, stocks have performed slightly better than average after hitting all-time highs. While this time could be the exception, history demonstrates you have a better than average chance of returns greater than zero over the following 12 months.
Market highs are a weak indicator of returns over the next 12 months.