Are Stocks Expensive?

Are Stocks Expensive?

When investors talk about the market’s price, they are generally deciding whether they should invest or not. If anyone tells you they know where the market is going, based on price or any other criteria, especially in the short term, you need to take that advice with a grain of salt. Fear and greed drive the markets in the short term, and fear works much quicker. When investors are feeling euphoric, they will come up with reasons why the world has changed and prices should be this high. When pessimism pervades, reasons to own stocks at any price are hard to find.

The S&P 500 finished 2014 up 13.68%, the third year in a row for double digit gains. As I mentioned in a previous blog (click here to read), this has only happened six times in the last 150 years. Therefore, looking back does not give us any insight.

The current Schiller P/E (price to earnings) ratio is at 27.1 times earnings, compared with the long-term average of 16.6. This would suggest stocks are pricey. To put this in perspective, the measure was 13.3 in March 2009 – just before U.S. stocks began their rebound.

The reading is nowhere near its 1929 peak or its all-time high of 44.2 in December 1999. Of course, we know what happened a few months after that.

From this perspective the S&P is about 63% higher than its average. Even when you look at forward earnings, stocks don’t look cheap-17.1 versus an average of 14.1.

Of course the same things could have been said about the market being overvalued by these measures two years ago. The market may be more stretched, but if you had jumped out trying to avoid a correction, you would have missed the +40% gain in the S&P over the last two years.

Maybe there is a reason why stocks are so expensive. Quite frankly they only look expensive if you don’t look at bonds. Interest rates have been kept artificially low for an extended period of time. The average yield of the 10-year Treasury Note is 6.47% while the current rate is only about 2%. With yields at all-time lows, stocks have offered investors better returns, therefore justifying an increase in the multiple. You would expect this to happen looking at stocks as a discounted sum of the expected earnings. As rates go up, the discount increases which reduces the present value of those earnings, lowering the value of the company’s stock. As long as yields stay low, stocks should trade at a higher P/E.

But the Fed will probably increase rates later this year based on the strength of the U.S. economy, probably just .25%. Nothing is firm now; it all depends on the economy. Growth last year was not bad, we started off poorly because of weather, had a good pick-up in the 2nd qtr. 5% growth in the 3rd qtr. and 2.2% growth in the 4th. For the year, GDP grew 2.4%. In 2013 it was 2.2%. Not great, but not bad. Unemployment, official unemployment, is down to 5.5%.

Compared to the rest of the world, the U.S. looks like a pretty good place to be, and if gas prices stay at these levels consumer spending could persist. I will caution you though: economic growth and a rise in stock prices do not go hand in hand. Stocks tend to outperform when economic conditions are not good but the potential for improvement is high, and tend to underperform when the economy is strong and there is a greater potential for negative surprises. Most of the economic numbers for the 1st quarter have not been that good.

To sum up, stocks do not look cheap, interest rates will most likely rise soon, making bond prices decline. It doesn’t sound good, but there are always reasons to invest and vice versa. Remember, stocks tend to climb a wall of worry. When things look rosy, that’s usually the time for caution.

As always, I don’t believe you can win trying to time the market. Stay diversified, and if stocks continue to go up, you’ll participate, but if they go down, your portfolio will not be as affected.

 

Washington Trust Bank believes that the information provided 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.

 

About The Author

Rick Cloutier, CFA is the Chief Investment Strategist for Washington Trust Bank with over 25 years of portfolio management and investment experience. He is responsible for directing the portfolio management, research, and trading activities for the bank’s multi-asset class strategies. He is also responsible for overseeing the client portfolio manager team and portfolio analytics team. 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, the Journal of Business Management and Economics, and 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.