Need EFebruary 10, 2021 -
Categorized in: IAG News
Most Americans do not like being called needy. It conjures up images of weakness, vulnerability, and dependency in a culture that tends to favor rugged individualism.
Yet, if there was one phrase I would use to describe the stock market at this point in time it would be need E.
One of the more commonly accepted methods of gauging where stocks are on the “expensive” to “cheap” continuum is the price to earnings ratio (or P/E ratio for short). This method divides the price of a stock by its earnings over the past twelve months (P/E ratio) or by its projected earnings over the next twelve months (NTM P/E ratio).
Looking at a broad-based U.S large cap stock index such as the S&P 500, we find that right now the stock market’s NTM P/E ratio is significantly above historical averages. According to data from JPMorgan, the average NTM P/E ratio over the last six years has been 17.45. This means, on average over the last six years, traders have been willing to pay 17.45 times anticipated annual earnings for stocks.
As of Friday, February 5, JPMorgan lists the current NTM P/E ratio as 22.10. This means that if traders applied the historical average NTM P/E ratio of 17.45 to the S&P 500’s anticipated annual earnings on Friday, the S&P 500 would have closed around 3,068. Instead, it closed at a record high 3,886.83 – roughly 27% above “normal.”
Mentioning that stocks are potentially 27% above their historical valuations could cause some folks to sell stocks in a panic. We don’t recommend that as valuations tend to be a horrible indicator of near-term stock market direction. Overvalued stocks can become even more overvalued. Undervalued stocks can become even more undervalued. Traders’ emotions are not tied to valuations.
There are typically two conflicting forces that will determine how and when stocks return to “normal” valuations. One option is for P (price) to decline. The other option is for E (earnings) to rise. Sometimes this battle is waged over a month. Other times it is waged over several years.
Since we don’t know how long the battle will be or which force will emerge victorious, our investment philosophy remains consistent – only allocate the portion of your portfolio you do not need for cash flow within the next eight years to stocks and persistently rebalance your portfolio to your personal Portfolio GPS®.
Only time will tell how today’s relatively high valuations will be resolved, but most people would find it more enjoyable with rising E than falling P. Thus, we believe the stock market is currently need E.
Quote of the week: Benjamin Graham, The Intelligent Investor: “The intelligent investor realizes that stocks become more risky, not less, as their prices rise – and less risky, not more, as their prices fall. The intelligent investor dreads a bull market, since it makes stocks more costly to buy. And conversely (so long as you keep enough cash on hand to meet your spending needs) you should welcome a bear market, since it puts stocks back on sale.”
Securities offered through LPL Financial. Member FINRA/SIPC. Investment advice offered through IAG Wealth Partners, LLC, (IAG) a registered investment advisor and separate entity from LPL Financial.
The S&P 500 is an unmanaged index of 500 U.S. large cap stocks. One cannot invest directly in an index.
Past performance is no guarantee of future performance. In fact, the opposite can be true. The information contained in this report does not purport to be a complete description of the securities, markets, or development referred to in this material. Investing involves risk including loss of principal.
Any opinions are those of IAG and not necessarily those of LPL Financial. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. No strategy assures success or protects against loss. Investing involves risk including loss of principal.
This photo by Unknown Author is licensed under CC BY-SA