With all the talk of QE, Europe, and the fiscal cliff, investors can lose track of the fundamentals. And for a classic barometer measuring the value of the stock market, one could look at the price-to-earnings ratio (or PE). This ratio is numerical shorthand for the relationship between the stock price and earnings of a company, or index. The PE ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investment—assuming, of course, that the company’s earnings stay constant. So, all else being equal (which is oftentimes difficult to say with financial markets), investors prefer companies with low PE ratios.
There are many ways to compute a PE. My PE is calculated using a 5-year rolling average based on S&P reported earnings (not operating earnings). By using this methodology, I effectively limit some of the accounting shenanigans that companies undertake, while also reducing some of the market’s cyclical volatility.
As you can see from the chart above showing a historical look at the PE ratio and S&P 500, the current 5-year average PE sits at 23.4. We have come significantly off the low of roughly 14 set back in 2009, and are now above the 70-year average of 20. From a valuation perspective, this is extremely good news for the following two reasons: (1) an above the mean reading while still climbing indicates that the market wants to expand the multiple. In cyclical bull markets, one way that stock prices appreciate is through multiple expansion; (2) the valuation, although becoming slightly rich, is still far away from bubble territory (like the just below 40 reading in the late 1990’s, or the valuation seen in the mid-2000’s) even after the 100%+ bounce off the S&P’s March 2009 lows.
Although this chart can be taken in a positive light, it is also important to realize that valuation is rarely a sufficient reason to be long or short the market. In other words, just because the market’s multiple is expanding and is now relatively fairly valued even after such a run does not mean that we cannot fall precipitously from here. Even absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down. QE and Europe are both pushing and pulling momentum investors on a daily basis. Additionally, one cannot assume that we’re in a cyclical bull market. We’ll have more to say on this in a future blog. But an expanding multiple that can also be considered reasonable is encouraging when supplemented by other positive trends.