Published October 15, 2021
There is always plenty of talk about whether the stock market is ‘fairly’ valued, expensive, or cheap. It is a question without an answer; there are only opinions. Because in the marketplace, the price is determined solely by what investors are willing to pay. The price of bitcoin and other cryptocurrencies is a good example. The currencies have a value almost entirely derived by supply and demand, which is almost entirely driven by sentiment. There are some uses for the currencies. But they remain, by and large, vehicles for trading with little or no real tangible asset behind them. What the ‘fair’ price of bitcoin is on a given day is only determined by how much investors are willing to pay on that day.
Stocks are a few steps removed from that process in that companies almost always have at least some level of tangible assets supporting their price. How much someone is willing to pay for those assets and the ability of those assets to generate cash flow and earnings will vary by the minute and by the investor. Thus makes a market. The brief below from Delta talks about the current valuation of the stock market while providing some context as to what ‘fair’ value is. We think it’s worth reading as the market largely churns sideways trying to determine whether the future prospects of the market’s collection of stocks is becoming brighter or dimming.
“Consensus analysts’ estimates for the S&P 500 earnings in 2022 is $220.47. The S&P 500 index is trading at about 4430 currently. If we divided Price (P, 4430) by earnings (E, $220.47), the S&P 500 P/E on 2022 estimated earnings is roughly 20x. Based on these inputs, that is the number. Is it “fair?”
Is it “fair” is a complex question. The Price/Earnings (P/E) multiple is both a mathematical and investor sentiment measure. From a mathematical perspective, P/E is a ratio with a numerator and denominator. Changes to these inputs mathematically cause the ratio to change.
The difficult part of understanding if the P/E is “high, low or fair” is the investor sentiment aspect. Is investor confidence too high or low. Are investors accurately predicting future events like GDP growth, earnings growth, interest rates, etc. Is the risk premium at an appropriate level?
Dollars paid to you in the future are worth less than dollars paid to you today. Dollars to be paid in the future may not be paid at all and they will be paid in depreciated dollars because of inflation. If you are handed a dollar today, you may invest it “risk-free” in a one-month US treasury and presumably have more money in the future. This is why we discount future dollars/earnings back to a present value today.
The risk-free yield today is nearly zero. All of the future expected return of the market is essentially the risk premium. The S&P 500 is currently offering an earnings yield/risk premium of about 5%. Fair?
Relative to prior market peaks in 2007 and 2000, this is very fair. The risk premium in those years was either flat or negative and the risk-free rate of return was in excess of 5% in both 2007 and 2000.
P/E includes a viewpoint on profitability and growth. Today’s leading companies dwarf companies of ten and twenty years ago in terms of size, growth, and profitability. Apple’s market capitalization is currently $2.3 trillion. Microsoft is $2.2 trillion. Google and Amazon are on their way to $2 trillion. Ten years ago, the largest company in the stock market was Walmart. Its market capitalization was roughly $200 billion.
Relative to 10 and 20 years ago, profit margins of the S&P 500 have roughly doubled from about 8% to 16%. As the S&P 500 becomes increasingly dominated by Internet/information technology/software companies rather than by capital-intensive, old-economy companies like Walmart, Exxon and General Electric, profit margins should remain elevated relative to long-term trends.”
Our TimingCube models do not take P/E ratios into account.
Market Update
After five weeks of down-trending market behavior, stocks perhaps found their footing this week. But the week began with concerns over inflation and the specter of ‘stagflation’ weighing on investors. Stagflation occurs when economic growth is stagnant while prices rise, thus squeezing profit margins. Stocks fell -0.7% Monday with oil and industrial metals prices adding to their recent rises; hence the inflation worries. Another -0.2% slip Tuesday as investors marked time awaiting the first of quarterly earnings reports with banks providing much of the reporting this week. An inflation report Wednesday came in hotter than expected. But markets took it in stride with interest rates actually dipping on the news. Bank earnings began with a mixed showing, though stocks closed the day up +0.3%. A powerful rally was launched Thursday as investors cheered a wide range of earnings. Reports from United Healthcare (UNH), Bank of America (BAC), Walgreens Boots Alliance (WBA), Morgan Stanley (MS), and Citigroup (C) all led to sizeable gains in company stocks. The broad market pushed upward by +1.7% with every market sector posting gains. In another sign of the strength of the move, the market’s index of investor concern, the “VIX” volatility index, plunged Thursday to its lowest level in five weeks. The trend continued Friday with another +0.7% gain. Well-received earnings news from trucker JB Hunt (JBHT), finance company Goldman Sachs (GS), and aluminum giant Alcoa (AA) provided the fuel for further optimism. One negative was the retreat in smallcap shares as the Friday trade progressed.
A solid week on Wall Street with the bulls finally showing strength to at least give pause to the market’s September swoon. The S&P 500 (SPY) popped upward by +1.83% while the Nasdaq 100 (QQQ) rose +2.15%. Smallcap Russell 2000 (IWM) recovered +1.62% but remained locked in its months-long sideways trading channel.
Warm wishes and until next week.