Most of you know that I’m not a big fan of buying or selling stocks based on P/E levels. But, I do like to look at them in conjunction with several other indicators to see where they are based on history. Below is a picture of the S&P 500 (white) with the P/E ratio (price divided by earnings) (green). According to Bloomberg, the P/E ratio on the combined 500 companies in the S&P is currently 24.55. Now, most analysts when discussing the P/E ratio use the forward looking P/E. I think generally that helps them justify in buying expensive stocks at current prices. They’ll say things like “the P/E ratio based on 2012 earnings…..” You’ll see from the picture below that the estimated P/E is around 15. Higher earnings, lower P/E.
In March last year, the P/E ratio went below 10 making stocks cheap. Yes, actually cheap. But, are they cheap now? The graph above goes back to 2004 and you’ll see the P/E ratio averaged about 16 until October 2008. What’s interesting is that the P/E ratio didn’t go up for the last several years even though the S&P 500 itself was reaching new highs. In a nutshell, earnings (profits) were keeping up with prices so higher prices were justified. Obviously, a consistent P/E didn’t stop the market from crashing which is why P/E ratios aren’t the best indicators for valuing stocks. Now, look at the graph from March 2009 until present and you’ll see that the P/E ratio has been rising at a faster rate than the stock market. So, stocks are becoming more and more expensive.
So, why aren’t people selling stocks based on this? It all goes back to what I said at the top. Investors buy stocks or sell stocks based on the future expectations and cash flows. And they buy or sell stocks based on their willingness or unwillingness to assume risk. Most expect earnings this year will be higher which means stocks aren’t as expensive as they seem. The problem is that I don’t have confidence in any analyst that can tell me how much the earnings of the S&P 500 will be in 2010. They don’t even know how much earnings will be next month.
This isn’t a call for you to run out and sell stocks. But, continue to watch what companies are saying and what they are reporting. If earnings don’t improve as expected, stocks will begin to fall (see Whole Foods & Starbucks a few years ago when their stocks were priced for perfection). There’s no sign just yet this stock market has topped but certainly stocks aren’t cheap. With that said, it’s too early to tell if they are too expensive. As usual, pay attention.
Through A Trader's Eyes 