The recent push by U.S. stocks into record territory reignited concerns that prices have outstripped fundamentals. And by most traditional yardsticks, American equities are expensive. But how much does that really matter?
As with individual stocks, a primary method for determining how expensive the overall stock market might be is through its price-earnings ratio, which compares profits with that of a benchmark, such as the Standard & Poor’s 500 index. Ratios can be calculated looking at backward or forward earnings over various time periods, or by comparing those readings to something else, such as interest rates or inflation.
Each method has strengths and weaknesses.
Let’s start with the “backward” methodology, which looks at the profits of a benchmark’s constituent companies over the previous 12 months (BetterInvesting’s preferred method). By that metric, U.S. stocks are clearly pricey. As of February, when stocks broke through to a series of record highs, the S&P 500 index was trading at 26 times trailing earnings, or 75% above its long-run average.
One glance at the historical chart, however, reveals a potentially serious weakness of the backward-looking P/E: Stocks can appear most expensive at the beginning of bull markets. That’s because earnings usually bottom during the late stages of a recession, precisely as stocks begin to rally.
The forward-looking P/E removes some business cycle distortions, and by that method, valuations don’t appear as stretched. According to a valuation model devised by Yardeni Research, large-cap U.S. stocks recently traded at 17 times 12-month forward operating earnings, or about 20% above the benchmark’s long-run average. But critics of the forward-looking P/E note that earnings estimates are only educated guesses that often turn out to be spectacularly wrong at market turning points.
Finally, there’s the twist on the backward-looking P/E devised by legendary investor Benjamin Graham in the 1930s and recently refined by Yale University professor Robert Shiller. Shiller’s cyclically adjusted P/E ratio (CAPE) compares the current level of the S&P 500 to the last 10 years of underlying earnings, adjusted for inflation. As of January, the CAPE resided a worrisome 75% above its historical average.
So what to make of all the numbers?
First, the market’s overall P/E might obscure fairly or bargain-priced individual stocks. Second, valuation is not a useful predictor of near-term performance. Third, the CAPE numbers imply that total returns over the next decade will be below historical averages, though not necessarily negative. And finally, earnings growth will be the key to the market’s performance over the remainder of 2017.
In other words, the “P” probably isn’t going anywhere soon without more “E.”