By Scott Brown EBS CONTRIBUTOR
It is truly unprecedented how many times the word ‘unprecedented’ has been used in 2020. Or is it? When we consider that we’ve dealt with COVID-19, passing the CARES Act, racial tensions, riots, natural disasters, and political divisiveness maybe we shouldn’t be surprised. However, something that should be surprising to almost anyone is the unprecedented (that word again) recovery in the S&P 500 following what I like to call the” COVID collapse.”
The S&P’s journey from record high to bear market in just 22 days followed by another new all-time high, just 126 trading days later is well…you know. But is it sustainable or even reasonable? I’m not sure but I do hear Gordon Gecko from the movie Wall Street stating simply, “Greed is good!”
But I digress. Us money folks don’t ever have all the answers related to market and economic behavior, but we do have a few tools to assist us in our analysis along the way. These tools or valuation metrics are financial ratios that compare a stock price (or total market index, sector, subsector etc.) to earnings, book-value, sales, dividends, cash flow or many other metrics.
There are many valuation metrics and models, but I’d like to focus on arguably the most commonly used metric: the Price-to Earnings ratio or PE ratio. The PE is a number calculated from the price per share of the stock divided by the earnings per share of that stock for the last 12 months.
On Sept. 14 the S&P 500 closed at 3,383.54 with a PE of 29.09 of trailing 12 month combined earnings for the S&P 500. Simply put, it would take 29 years of the last twelve months (Sept. 15, 2019-Sept. 14, 2020) earnings added together to equal what the S&P 500 is trading for today. Sound expensive? It should, but it’s not that simple.
For example, during World War I in December of 1917 the lowest PE ever recorded was 5.31. Stocks were arguable very inexpensive but possibly for good reason. The threats to the global economy and freedom worried investors and they preferred precious metals, bonds, and cash. Conversely, in May of 2009 at the height of The Great Recession the PE was 123.79. This occurred amid a sharp economic slowdown caused by a collapse in real estate prices, failing mortgages, rapidly declining earnings and high unemployment.
The S&P 500 fell 57 percent from peak to trough but stocks never fully reflected the drop in earnings because investors thought that regulatory stimulus actions like TARP, historically low interest rates and other global central bank and regulatory actions would eventually turn things around for the global economy. Many weren’t willing to throw out their stock portfolio.
PE ratios alone do not accurately reflect fair value for individual stocks or the broader equity markets. For reference, the historic median PE of the S&P 500 is 15.82. Some common themes around using PE include faster growing companies enjoy higher PE’s, established companies with stable earnings enjoy mid-range PE’s and companies whose earnings are falling have lower or even collapsing PE’s. In conclusion, just because a company’s PE ratio is low and perceived to be cheap does not mean it’s a good buy. Nor does a high PE mean the company’s stock price is going to fall.
I realize I have not answered the question, ‘Is the market overvalued?’ I do hope I have given you tools to begin to make your own determinations on stock and equity market valuations going forward. In these crazy times the Steve Miller Band might advise you to, “Take the Money and Run,” but as a wealth management advisor I would remind you that a penny saved is one that holds some value so context and analysis are important as is a diversified portfolio coupled with a goal-oriented long-term plan. One thing I believe for certain is to get the most value out of life you should always strive to enjoy the ride!
Scott L. Brown is the co-founder and managing principal of Shore to Summit Wealth Management. His wealth management career spans more than 25 years and he currently works and lives in Bozeman, MT with his wife and two sons.