This is a question that has been making headlines for at least a couple of years now. Even the Fed has jumped into the debate; the Federal Open Market Committee’s June minutes revealed it as a topic of discussion. A measure often used when examining valuation is how much investors are paying for every dollar a company earns – more commonly known as the price to earnings or P/E ratio. The current Schiller P/E ratio is 30.4. That compares with the long-term average of 16.8, which would suggest stocks are overpriced. The reading is still below its 1929 peak or its all-time high of 44.2 in December 1999.
But the Schiller P/E ratio is backward looking; it considers price against past earnings. Stocks are priced off expected future earnings. To determine the value, we discount expected future earnings back to today’s dollars. Unfortunately, even when you look at forward estimates, stocks are not cheap – 17.9 versus an average of 15.
But the counter argument goes something like this: investors don’t buy stocks in a vacuum, they look at other available investments to make their decision and buy on relative value. Yields on bonds are so low, which makes stocks attractive because There Is No Alternative – the so-called TINA effect. This argument may be true, to a point. If stock prices become so expensive that the probability of a positive return becomes remote, most people would hold on to their money rather than invest, or place a bet.
Supporting the TINA effect argument is the fact that interest rates have been kept artificially low for an extended period. The historic yield of the 10-year Treasury note has averaged 6.47% while the current rate is only about 2.25%. That’s the equivalent of paying $44 for every $1 in interest income. When you compare that to the stock market’s P/E ratio, stocks look relatively cheap.
Beyond value, let’s consider supply. Over the last 21 years the number of American companies listed on the exchanges has declined from over 7,000 to under 4,000. Additionally, while fewer firms are going public, acquisitions have been on the rise, further reducing supply. If demand remains stable, prices should move higher.
Also, the S&P is market weighted with only the largest names driving valuation. The top 100 stocks account for 65% of the index’s value, leaving the remaining 400 names closer to historic norms.
So, what do we think? The economy is slowly growing with inflation in check, which is generally good for stocks. However, we think stock prices are inflated, but we also believe that, due to low interest rates, stocks prices should be above their historic norms. Therefore, we advise caution.
In the end, there is no specific price or ratio at which stocks should be ideally trading. Too many factors affect valuations. We know that stock valuations are not a good indicator of what is going to happen in the near term. In other words, even if stocks are expensive, it doesn’t tell us a correction is imminent.
Take our current market for example, values may be more extended now, but prognosticators were saying the same thing about stocks four years ago. If you had listened then, and moved to cash, you would have missed the 60% gain in the S&P. No one knows what the market will do next, but using market valuation to time your investing is not a profitable endeavor. However, market valuation does give us a good indicator of stock returns over the long term. In other words, because stocks are expensive today, prospective returns may not hit their historic norms. Consequently, when calculating portfolio growth, it is probably not prudent to use historic averages in your estimates.
For a discussion on the topic, please look for our upcoming video.
Content for this blog post was provided by Matt Clarke, Client Portfolio Manager.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Rick Cloutier, CFA is the Chief Investment Strategist for Washington Trust Bank with over 20 years of portfolio management and investment experience. Rick designs and implements investment and risk management strategies for the bank’s clients. Rick has written numerous articles for Investopedia and wrote a weekly column for the Fall River Herald News in Massachusetts. His research has appeared in numerous journals, including the Journal of Investment Management and Financial Innovations, as well as, the International Journal of Revenue Management. He provided a nightly commentary on WALE radio and authored the novel Caveat Emptor. Rick earned his MBA at Boston University.