Recent volatility and decline in the broad markets in the U.S has people wondering if the correction returned the market to typical valuations. There are several tools used to measure the market’s value. One of the most widely used is the price/earnings (P/E) ratio, derived by dividing a stock’s price by its trailing twelve months (TTM) earnings.
The P/E ratio on the S&P 500 stands at 24.46 as I write (February 11, 2018). The ratio has been above 20 since early 2015.
When you take long periods of market data and shake them together you end up with an average P/E somewhere in the mid-teens. There is no hard and fast rule stating what a fair or reasonable P/E should be though plenty of opinions exist.
Another way to look at the P/E ratio is to flip it upside down where you divide the earnings by the price. This is called the earnings yield.
The earnings yield is an easier way to understand if your investment is paying enough to justify the risk and lost opportunity cost of investing elsewhere. The S&P 500 earning yield is 4.09% as I write. This means if all the companies in the S&P 500 paid all their earning out as a dividend you would have a 4.09% yield.
Again, there is no hard and fast rule on what an appropriate earnings yield should be. However, if Treasuries are considered a risk-free investment and yield more than 4.09% you might want to reconsider your strategy.
History of the P/E Ratio
The P/E ratio has been all over the map. We sit near record highs in the ratio currently, but have been above 20 for several years. This in and of itself is a bit unusual.
The other side of the spectrum had the ratio in the single digits with the earnings yield double digits. (If the P/E is 10 then the earning yield is also 10%. If the P/E is 5 then the earning yield is 20%. Example: A $100 stock has a $10 per share profit. If they paid all the profit as a dividend it would equate to a 10% yield. If the $100 stock earned $20/share the P/E (100/20) would be 5 and if the $20 were all paid out it would equate to a 20% yield.)
The actual dividend is almost always less than the profits of the underlying company as a higher dividend would require borrowed money or liquidation of assets to pay. The earnings yield is the highest amount a company could consistently pay out. Realistically, most companies can’t pay more than 80% of profits in dividends so resources are available to invest for future growth.
The P/E ratio has climbed above 20 many times in the past. Concerns over high valuations based solely on the P/E is short-sighted and a poor investing barometer.
Up until the early 1990s when the P/E climbed above 20 either earning grew bringing the ratio back below 20 or stocks declined in price or some combination of both. Since the early 1990s the ratio has been above 20 more often than not. During the dotcom craze the ratio exceeded 40 and during the Great Recession (2008-9) the ratio briefly pierced 70 as earnings declined (especially in the energy sector) faster than the market declined.
In both cases the excessive P/E ratios returned to the upper teens in a short period of time. Earnings rebounded even as stocks advanced. The faster growth rate in profits reduced the ratio. The excessive losses due to falling oil prices eventually ended and the ratio declined.
Why is this Time Different?
Why have stock prices stayed so high for so long? Except for brief periods the P/E has been above 20 for twenty-five years! This has never happened before in U.S. markets.
‘This time is different’ is the battle cry just prior to bloodlettings. History doesn’t repeat itself, but it does rhyme. Each era of stock market history has different events moving prices. If you dig down you will find the differences are only cosmetic.
What drove stock prices in the past drive them today.
The P/E chart shows the ratio climbing steadily from the early 1980s until shortly after the turn of the millennium where it made traumatic moves as it settled into the lower 20s zone.
What caused this steady ratio increase? First, the increasing ratio means the stock market has been climbing faster than earnings for a long time. People are paying more and more every year for the same dollar of earnings. At first blush this seems insane. But there is a valid reason for the activity.
Inflation was rampant (double-digits) in the late 1970s. Interest rates were increased repeatedly by the Fed until borrowing costs reached well into the double-digits.
After years of high interest rates to fight inflation, the price of goods and services stopped the rapid climb. The back of inflation was broken. Price increases moderated. Each economic hiccup reduced price pressures further until the 2008 recession when deflation (declining prices) made an appearance.
With each step lower, interest rates dropped in tandem with inflation pressures. It’s been so long since we felt the sting of inflation most people investing today don’t remember what it was like. A certain accountant in the room does, though.
Inflation and Stock Prices
Many factors drive stock prices. Earning top the list. But what is the value of those earnings?
Why did investors pay less than 8 times earnings in 1980 and now pay close to 25 times? Investors today pay three times what they did in 1980 for a dollar of earning!
In 1980 inflation was high; today inflation is low, almost nonexistent, and has been for a decade.
Inflation drives interest rates. The higher inflation the higher interest rates will climb.
If prices are steady (no inflation or zero inflation) and a company grows earning 10% the future value of those earnings are worth their full value.
If the same company were operating in a 5% inflation environment the discounted value of those future earnings are reduced by half. (This is an over-simplification to keep our story moving. Each successive year earnings are reduced by the risk-free rate of return. It has a compounding effect.) That means investors will pay less for those earnings. This is why investors pay three times what 1980 investors did for the same dollar of profits.
Future Growth Problems
When inflation climbs, interest rates follow and hence the risk-free rate of return.
As interest rates climb on the risk-free alternative (Treasuries for U.S. business and investors) it gets harder to justify many projects considered for future growth.
Value is created when the return on invested capital exceed the cost of capital. The cost of capital on excess cash held by businesses is the risk-free rate. When Treasuries pay almost nothing virtually every project projected to show any return is viable. Increase the risk-free rate to 5% or higher and many projects no longer make sense.
Of course, a margin of safety will be added by the company. In a zero rate environment a company will not accept a project with a projected rate of return of 1% just because it exceeds the risk-free rate. They will need a margin of safety to account for errors in calculated returns and to compensate investors for the risk taken.
As rates rise and fewer projects are approved, the number of goods and services eventually declines along with the number of jobs until equilibrium is found.
What Could Cause Inflation and Lower Stock Returns?
For 35 years investors have watched stocks climb faster than earnings. Deflationary pressures were more common in the 19th Century as prices swung wildly with the economy’s ups and downs. Over long periods prices were stable with the exception of the wild internal fluctuations.
Refer back to the P/E ratio chart. You will notice three times in the last 150 years the ratio dropped below 10 for an extended period: after WWI, after WWII and during the late 1970s. The starting point of the chart showing a low ratio came right after the U.S. Civil War.
At first glance you might think war was the cause of low P/Es, but you’d be wrong. Then you might wonder why the most pronounced period of low P/Es was the only one not following a war.
Well, the 1970s low P/E ratios followed a long war in Vietnam. War seems once again the cause of a low market ratio.
War does funny things to an economy. Both World Wars had price controls as the U.S. dealt with the economic stresses of fighting the war. Pent up demand and a higher savings rate allowed people to chase goods and services they were denied for a period of time. Business ramped up production and prices stabilized. With prices under control investors calculated the future value of earning at a higher rate causing the P/E ratio to climb.
The 1970s had additional issues pushing prices higher. Spending to fight the Vietnam War primed the pump for price increases. The first oil embargo in 1973 sent energy prices rapidly higher. President Nixon took the U.S off the gold standard further unleashing prices as the Federal Reserve had no real limit other than self control on how much money they could pump into the system.
Stubborn inflation was pushed even higher with a second OPEC oil embargo in the late 70s.
Now inflation became entrenched. Killing the beast wasn’t going to be easy. People expected wages and prices to climb. It felt normal so the tendency was to push prices higher.
This may seem strange to people living in a world of remarkable stable prices. But that could all change and rather fast.
Stagflation was a new animal for economists in the 1970s. A stagnant economy still generated large price increases. It made no sense.
The newly elected President Reagan had an idea. He built a tax cut around combating stagflation problems with supply-side economic theory.
Supply-side economics has received a bad rap at times, but it was the perfect medicine for low economic growth and high inflation.
What the 1981 tax cuts did was lower rates for business and individuals. This could cause inflation to flare higher. Buuuuuut . . .
For businesses some expenses are depreciated. Back then small businesses had to depreciate assets expecting to last more than a year and costing more than $100. This kept businesses from increasing production as costs came 100% out-of-pocket (or from borrowed money) while it took years to depreciate the entire asset.
What Reagan did was genius! Before the two big tax changes of the 1980’s small businesses could elect to expense assets (IRC Section 179) up to $10,000 with certain limitations instead of depreciating. The tax law was changed to increase this to $20,000.
Small business owners could now write-off more of their investments immediately. Businesses responded. Capital investments increased requiring more employees. The extra supply brought down pricing pressures.
Over the next decades Section 179 asset expensing was constantly increased until it was well into the six figures. Bonus depreciation is similar to Section 179, allowing for additional current deductions for asset purchases. Section 179 and bonus depreciation are so high now any further increases have no real effect at sparking additional economic growth.
Primed for Inflation
The medicine needed to kill inflation worked. Unfortunately, the same medicine was used again and again driving down inflation until deflation was the issue.
Supply-side economics has run its course until the next round of inflation appears. Supply-side tax bills don’t have the desired effect to the chagrin of politicians. Might I suggest to the elected officials in Washington to think of something new once in a while.
Back in 2008 the Fed’s balance sheet was under $1 trillion. It now stands at $4.5 trillion! This is one of the biggest, if the not the biggest, percentage increase in the nation’s money supply in such a short period. Even major wars didn’t create so much additional money.
Once again, this time was different in the details. All the excess money creation was sopped up by central banks around the world and the Fed. (Yes, the Fed holds much of its own money! The offsetting entry in the ledgers is held by the balance sheets of money-center banks to make them look solvent when they had lots of bad loans.)
Lots of new money didn’t cause inflation because it never hit the economy; it’s like it didn’t exist. Money in bank vaults might be a neat gimmick to make banks look sound during an economic crisis, but it does nothing to spur economic growth.
All the money in bank vaults didn’t disappear. It was waiting for a spark to be release it. That spark came late last year with the Tax Cuts and Jobs Act. Gas was thrown on the flames with an additional $400+ billion in new spending in a bill meant to keep the government open.
To Infinity and Beyond
The money is printed and the match lit. It is of vital interest to investors what happens next.
When the P/E ratio climbs as it has over the last 35 years the stock market advances at a rate faster than earning growth. The opposite happens when the ratio declines!
I have no crystal ball. Predicting where the stock market goes next is a fool’s errand.
With the facts listed above there is ample concern for an underperforming stock market for an extended period. Those most at risk are those in retirement, just entering retirement or retiring in the near future.
History is clear. Inflation causes higher interest rates and lower market multiples. Higher earnings can keep the market ratcheting higher, albeit at a slower rate as investors pay less and less for each dollar of earnings as inflation increases.
Excess money thrust into an economy has a high probability of affecting prices. The current economic experiment is gargantuan. The pile of new money waiting for freedom has a green light. As money flows through the economy at normal velocity, the effects of the new money are magnified.
It could be self-feeding; it could be an old accountant reading the tea leaves wrong.
Ah, who am I kidding? My cup of hot tea is just fine! Massive new spending by the government means the balance sheets at banks look better so they can now lend out all that money they’ve been dying to earn a profit on.
I don’t know the future, but I bet it’s going to be one helluva ride.
Monday 12th of February 2018
It’s these kind of post that are informative but I have no idea what to do with that information. Its like my brain doesn’t understand that level of depth. So we just keep investing in our accounts with no real understanding on what to tweak nor what to ask a vanguard advisor.... 😣
Tuesday 13th of February 2018
I finished the article the same way Sarah. For me, after sleeping on the information, my takeaway was the viability of having a place for bonds in my portfolio. If I just look back at the last decade or so it feels like a losers game to have any money in bonds, I thought to myself "why would I have any money there when it could be working so much harder in equities?" As a new investor (like this time last year I had $0 in the market new), and as someone who has a decent ability to keep my emotions in check for economic decisions I figured I was good with no bonds. Since I'm really new to the game I plan to allocate money to bonds going forward but not re-balancing what I currently hold.
I do think that if you have a strategy already set it could be dangerous to try and readjust it every time there is new information or a new prediction. So maybe just knowing what could be ahead is all the action that needs to be taken, just being mentally prepared.
Monday 12th of February 2018
Sorry, Sarah. The reason I refrain from prediction is that it's so hard to do. I was asked to write a post on what I've done in the past. I might do that. Seeing what I've done that works and what failed is more instructive. This post was meant to educate. The environment is ripe for inflation. There are differences compared to the past so we'll see if I'm as smart as I think I am.
One thing I'd consider if inflation and interest rates rise is to consider long-term Treasury bonds. At 7% I start to plant some of my investments in 30-year Treasury bonds. The higher the rate climbs the higher the percent of my portfolio in bonds. Why? Because the long-term returns of stocks is 7%, plus inflation. Treasury bonds at 7% match the market without consideration for inflation and the interest is state tax free.
Monday 12th of February 2018
Great article like usual. I particularly like your historical analysis of P/E ratios.
Would really enjoy an article highlighting the actionable steps you have personally taken in the past during recessions (beyond increasing your investments in the stock market which mentioned last week)
Monday 12th of February 2018
MB, I can share what I did, but I usually catch hell when I do. Past actions were specific to the environment. I'm taking different steps today. The process is also evolving.
Jeff @ Maximum Cents
Monday 12th of February 2018
What are your 2018 earnings growth estimates for the S&P? It's important to look at the growth rate when making decisions if the market is overvalued.
Wise Money Tips
Monday 12th of February 2018
The market does seem overvalued by several measures. Just taking a look at a long term chart of the S&P 500 Index can make you nervous. Granted we've had a couple of rough weeks in the markets. But after several up years and all kinds of recent record highs and low volatility records, the recent declines must be put into perspective. The problem is no one can consistently predict what the markets will do. They can remain irrational longer than you can stay solvent. Experts have been calling for an end to the current bull market for years. Eventually, some of them will be right. It could be a few weeks, or a few years. That's why it's important to just invest selectively and/or gradually dollar cost average into the market for your long term investment goals. Money needed to meet short term goals (i.e., within five years) should not be invested in the stock market. If it is, you should be looking for exit opportunities.
Monday 12th of February 2018
I like the tie in with inflation, p/e, and stocks.
I’m very much in the economics camp of it’s probably not a good idea to play with monetary or fiscal policy significantly. When money is tight both can help, but both have a lag between inputting the money and usage. That lag can cause the money to hit at the wrong time causing inflation. That lag impact might save us this time too, ya never know.