Stocks have been hitting record highs on a regular basis over the past couple of years and that has pushed valuation measures to high levels as well. We have seen terms like “fully valued”, “richly valued” and the dreaded “overvalued” used to describe the markets since at least 2013 when the S&P 500 surged 32%, yet the markets have risen each year since then, so let’s look at current valuations and what they can tell us.
There are many different ways to measure stock valuations but we will focus here on the price/earnings (P/E) ratio, one of the most well-known yardsticks we use to look at value. The P/E is simply the price of the stock or index divided by its earnings. While the P/E is well known, there are many different ways to measure it. For example, we could use actual earnings over the past year or we could use the average inflation-adjusted earnings for the past 10-years (the Shiller P/E). These two measures, however, are backward-looking, in contrast to the actual stock market, which is always looking ahead. For this reason, I prefer to use the forward P/E ratio, which uses the future expected earnings for the next year.
As you can see in the chart below, there is no doubt that at 17.5x earnings the current P/E on the S&P 500 is higher than it has been in a long time and it is well above the 25-year average of 16.0x. However, this does not necessarily mean that the market is due for a dramatic sell-off for at least three reasons.
Source: J.P. Morgan Asset Management
The first reason is that the current P/E ratio at these levels is still only about one-half of a standard deviation above the 25-year average. One standard deviation is a typical definition of overvaluation and we are still well below the 19.2x it would take to reach that level.
Secondly, a drop in the stock market is not the only way for the P/E ratio to go down. Remembering our fractions lessons from school, a higher denominator means a smaller value. In this case, if earnings expectations rise and prices remain the same, the P/E ratio will decline. For the past several quarters, earnings have been coming in higher than expectations. Our economy keeps growing slowly, and now U.S. companies with overseas operations are beginning to benefit from the long-delayed improvement in international economies. Combine that with a slightly weakening dollar, and we have a good setup for an increase in future earnings expectations.
Finally, the P/E ratio is an inaccurate predictor of short-term market moves. Studies have shown that there is very little correlation between the level of the P/E ratio and the return on the S&P 500 over the next twelve months so it should not be used to try to time the market.
Even though the relationship with short-term market moves is weak, there is a stronger correlation between it and lower market returns over longer periods of time, such as the subsequent five-year period. Of course, the P/E ratio is just one of many tools we can use to try to determine whether or not the market is overvalued.