The first lesson in investing from my father, was that you should only buy stocks that have price-to-earnings (P/E) ratios under 10. Seemed like pretty good advice. Buying stocks that have lower P/E ratios means that you are buying stocks that are less expensive. I learned a lot of great financial lessons growing up in a small, rural Michigan town. One of the biggest lesson was to understand the value of a dollar and always find the best value out there. So, it comes as no surprise that my father’s first investing lesson was to buy low price, value stocks. I was taught that the lower the P/E ratio, the better (although I had no idea what the P or the E stood for at the time). So, shouldn’t I be scared of the current P/E ratio of the S&P 500? Not yet.
According to FactSet, the current P/E ratio of the S&P 500 Index is 23, which is nearly 30% higher than the long-term average for the index. Obviously, this means that the stock market is overvalued and no way should you be buying stocks at this level. Enter Jeff Kleintop, Chief Investment Officer for Charles Schwab and one of the best articles of the year. This chart shows how valuations are high, but that doesn’t mean anything for the next year.
This chart looks a lot like myself after a day at the driving range. A lot of random shots, scattered all over the place. As you can see in the chart, even though the market is expensive, there has been a lot more good years than bad years when the market is this expensive. In fact, from the article:
The current MSCI World Index PE ratio is 21.3. Since the inception of the MSCI World Index in 1969, a P/E in the range of +/- 0.5 around 21.3 (20.8 to 21.8) has been followed by a total return of -5% to +45%, with an average return of +17.5%. Though valuations are above average—reflecting the better than average economic and earnings environment, there is no reason to believe stocks couldn’t go higher over the next year and even produce double-digit gains based on nearly 50 years of history, although of course history is no guarantee of future performance.
Yes, markets are expensive, but this doesn’t mean all gloom and doom. In fact, we should be looking at a pretty good next year in the stock market, if historical data is any guide.
Still, if you want to be scared of the current P/E valuations, read this Yahoo! Article. If short-term returns are a scatter shot with really no rhyme or reason, longer-term returns do appear to be more predictable. Unfortunately, that isn’t such a good thing, given today’s higher valuation.
The chart above is the forward P/E ratio, which is current price of S&P 500 divided by the next twelve-months earnings estimate. The current forward P/E ratio of the S&P 500 is roughly 18. Given the chart above, this means you should expect about a 5% average over the next 10 years. This is pretty low, given a long-term average of about twice that return. Given the potential for lower stock returns and ultra-low bond yields, and the next 10 years may be scary for investors.
At some point the stock market will go down, and you will see that financial pundit bragging about how he timed the market perfectly. He will bring up the elevated P/E ratio, and mention that he knew it would go down. At the end of the day though, there is no correlation between the P/E ratio and short-term returns. I got plenty of calls a year ago from worried clients, stating the high P/E ratio of 20 at the time, meant that we were doomed for a market downturn. Over the past year, the market has returned over 20%. If you were worried about the high P/E ratio a year ago, you are going to hate where it is today. The market may be up or down 20% next year, but don’t blame it on the high P/E ratio. Yes, the market is expensive. No, that doesn’t mean we are destined for a market correction. If history continues, next year the P/E ratio will be even higher than it is today, and you will have even more reason to be worried about the stock market.