Are stocks overvalued? Is the market about to crash? The answer today is the same as it is almost every day: it depends on who you ask.
Even as we move into an economic recovery, it is increasingly easy in 2021 to find analysts who claim that stocks are
“obscenely overpriced,” “wildly overvalued,” or, as CNBC recently touted, that we have a stock market which is “the most-expensive… EVER by most measures.”
Where does this brimstone-laden attitude come from? In my view, it is primarily the result of faulty statistics which result in comparing current stock market prices to the revenue which businesses were earning during the pandemic. Last year, Covid was a once-in-a-generation experience. This year, it is creating once-in-a-generation analytical anomalies.
HISTORIC PRICE-TO EARNINGS, EXPLAINED
Many of the current branches of market negativity are outgrowth of the same tree. A technique among market pundits, which is as pervasive as it is rudderless, is to compare the current value of the stock market to what companies have earned historically.
The S&P 500 is often used as a proxy for the stock market. While it is a slight oversimplification, think of the Index as being the average value of the 500 largest companies in America. The S&P is currently priced at a level of about 4,200. Knowing this number alone will not tell you if the stock market is overvalued or undervalued; context is needed. The most common way to grade this is to compare stock prices to the amount which companies have earned in profit.
When you divide the current cost of a stock (or index) by the amount that it has recently earned, you arrive at a basic price-to-earnings ratio.
When you divide its current value of 4,200 into what companies earned over the last twelve months, the S&P 500 currently trades at a jaw-dropping price-to-earnings ratio of 42.70. If that level doesn’t give you the vapors, know that the average ratio in a low-interest environment is about 20. Is the stock market today, as indicated, trading at twice the typical level? Has madness taken the market?
“Yes and no,” I suppose. While it is literally true that stocks are trading at twice the level which they usually do compared to historical earnings, like all else, this fact is only useful in context. The needed context, by the way, can be summed up in one word: COVID.
Notice the “sleight of hand” in comparing stock prices today to what companies were earning during the pandemic. That is roughly as logical as agreeing to sell your house today based on what it used to be worth.
While these numbers might sound scary, Wall Street tends to value stocks based not on historical earnings but on future expected earnings. Equity prices today are generally an interpretation of what we think (hope?) companies will be worth eventually. The “forward” price-to-earnings ratio divides stock prices by what businesses are expected to earn in the future, based on either their own statements or on the estimates of analysts.
There is logical intuitiveness to this. Stick with the pandemic and think of one of my long-time favorite individual stocks: Disney. The company was uniquely affected by Covid. Not only is Disney the biggest global theme park operator and distributor to movie theaters, but they also own ESPN. You may remember a 2020 where theme parks, movie theaters, and sporting events were all shut down.
If you buy Disney stock tomorrow, how should you value it? Is it more important to you what happened to the company last year, or are you more interested in the profit a business expects once things have reopened? While both numbers have their uses, your preoccupation will be how much you stand to make as a new investor (not what the previous owner of your shares made).
The price-to-earnings ratio of the S&P 500 based on expected forward earnings is currently about 23. This is also elevated from recent averages which have between roughly 16 and 19 over the last few years. While this is not as inflated as the historical comparison, it would still lead to a reasonable assessment that stocks are modestly overvalued—IF forward earnings expectations are correct.
To decide whether stocks are overvalued from this level, the real question is whether you think companies are going to perform better or worse than the stock market is predicting over the coming year. After all, future earnings estimates are just that, estimates.
As this is written we are currently in the stock market’s quarterly “earnings season” where public companies announce recent performance and update guidance. So far this quarter almost every company— a record setting 85.5% —is doing better than Wall Street had forecasted. Even as the popular narrative asserts itself that stocks are “overpriced”, intrinsic data is being released one company at a time showing that many of those stocks have actually been undervalued.
My take on the market, then, remains that stocks are roughly priced fairly and stretching into overpriced if not combined with an expectation that an economic reopening has not been accounted for in in an effective manner. I continue to expect that companies are going to surprise analysts over the next twelve months, pushing into the first part of 2022, as the American public gets back into “spending mode”. If this thesis holds—and it has so far—it would not be a surprise for the S&P 500 to gravitate further by the end of the year based on earnings outperformance. While I’m not into “calling shots”, an additional 10% upside (pushing the S&P toward 4,600) wouldn’t be a surprise.
While I see probable upside, I would also expect a potentially volatile remainder of the year in which those gains could materialize. While driving the underlying market, positive earnings announcements can only hold the attention of Wall Street for so much of the news cycle. Earnings news would compete with inflationary concerns and the specter of tax hikes—both justified worries which could provide counterweights. For stock-heavy clients, a beneficial strategy would be to harvest additional gains as they materialize this year and to purchase more conservative and inflation-resistant assets with that growth. It may also be time to weight more toward international investments (foreign stocks will be made more attractive by American tax hikes and inflation).
As we say in the Midwest, this is a “long way around the barn” to explain that a while a recovery has been priced into stocks, potential upside remains. Covid-19 has created some scary sounding statistical comparisons, but a strong underlying economy remains which the disease failed to infect.
Anthony (Tony) Sueck
Retirement Income Certified Professional (RICP)™