Maybe. Maybe not. Investors may be forgiven some angst given the divergence of opinion regarding the valuation of U.S. stocks. While it is true that prices are near all-time highs, it is also true that no one knows the eventual top except in the rear-view mirror. And while the current valuation of the market is expensive by one reading of historical norms, there is ample countervailing evidence to support continued appreciation.
The most commonly cited valuation measure for individual stocks and for the market is the price-to-earnings ratio, or P/E. This metric is quoted often but frequently misunderstood or ill-defined. Strictly speaking it is the ratio of a stock's price per share divided by the company's earnings or profits per share over the past year. For a market like the S&P 500, analysts roll up the numbers for all the constituent companies into a P/E for the index. We the use this figure to help assess whether stocks are cheap or pricey relative to historical levels.
By this definition, the S&P 500 currently sports a P/E of 21. This number is higher than the long-term average, suggesting the market is rich. But analysts and commentators employ differing definitions of the P/E ratio, adding to confusion and making comparisons more complicated. A common variant excludes "extraordinary items" like onetime write-offs not expected to recur. By this construction, the current P/E of the S&P 500 is 19. Hmmm.
Additionally, many observers correctly note that what matters is the future and not the past, and so they attempt to estimate profits for the next year instead of tallying last year's. Plug this in, and your calculator spits out a more temperate "forward P/E" around 16 or 17. The plot thickens.
It is problematic that so many pundits opine upon the indispensable ratio but often dispense with a clear indication of which version. And many make the mistake of comparing one version against historical averages of another.
Another common error is to compare today's P/E (whichever version) with averages dating to the administration of President Garfield, when the New York Stock Exchange traded 1/100th of one percent of its current daily volume. If someone offers a comparison against the average over the last 115 years, chuckle knowingly and move on. Compared with a more relevant sample over the past 10 or 15 years, stocks are not that expensive.
All this is not to deny the utility of this important ratio, but to provide context. An interesting way to view the P/E is to literally invert it; divide earnings by price to get the "earnings yield" E/P, a measure of profit generated for each $1 of stock price. Comparing this ratio against the yield on other investments like bonds paints a more attractive valuation picture.
Currently the earnings yield on the S&P is about 6 percent, well above the 2.2 percent yield on 10 year bonds. Although not perfect, this measure suggests that unless interest rates rise sharply this year (unlikely), the stock market is relatively undervalued compared with bonds.
The earnings yield is also reasonably correlated with the rate of inflation over time. A sudden spike in inflationary expectations would likely send a chill through the stock market. But inflation is off the table for the foreseeable future, adding support to the case for stocks.
Statistically, the market is overdue for a decent correction sometime this year. But longer term, for patient investors, corrections are necessary and healthy. Stocks should continue to offer additional value given the significant earnings yield premium over bond rates that justifies a higher P/E. Buy the dips.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.