In July, major stock indices reached record levels. For the first time ever, the Dow Jones Industrial Average closed above 14,000. The S&P 500 achieved a record level as well.
Subsequently, there has been a sharp downturn in the market. Naturally, clients may wonder whether the record levels meant that stocks were overvalued, and whether this was a factor in the market drop.
We believe that stocks were reasonably valued in July, based on usual measures of valuation, and the record levels of July are not the culprit in the current weakness.
Stock Valuation
Analysts look at many measures to determine whether the market and/or individual stocks are overvalued. This is certainly true at BWFA, where we combine numerous fundamental measures of the overall economy with stock-specific measures. For example, we look at a stock’s price-earnings ratio. Understanding this ratio reveals why the overall indices can reach new highs and yet individual stocks and the overall market can be reasonably valued.
Valuing Individual Stocks
One common way to value a stock is its price-earnings (P/E) ratio. The P/E ratio measures how much investors are willing to pay for $1 of earnings.
Consider General Electric. General Electric earned $2.07 per share over the past 12 months and was recently priced at $37. Its P/E ratio was $37/$2.07, or approximately 18. This is roughly in line with the average P/E of all the stocks in the S&P 500. Given GE’s exceptional prospects in globalized markets, most analysts would argue that GE’s price is not out of line with its earnings prospects.
Stocks whose earnings are expected to grow much faster than the overall market will have higher P/Es. For example, a growth stock like Garmin has a P/E ratio of 36, partly because analysts expect earnings to grow by 20% per year for the next five years. On an historical basis, a P/E in the mid 30s is not too high for a company with these earnings expectations.
It is important to note that there are pitfalls involved in relying too heavily on the P/E ratio. Most notably, earnings can be “massaged” to make a company look more profitable than it really is. Enron, Worldcom, and others showed that there is considerable leeway in using Generally Accepted Accounting Principles (GAAP) accounting methods to produce a corporation’s bottom-line earnings-per-share figure.
Another point to keep in mind is that the earnings number in the P/E ratio can be composed in various ways. Analysts frequently quote the ratio based on the past 12 months’ earnings. Sometimes, however, P/E is quoted in anticipation of next year’s earnings. Sometimes, analysts use two quarters of actual earnings and two quarters of expected earnings to arrive at a P/E ratio.
P/E of the Market
Even though an individual stock may offer reasonable value, it is possible that a preponderance of high P/E stocks will create an over-valued market. To examine this possibility, BWFA looks at the market-weighted P/E of the indices.
From Dec. 31, 1999 to the present, the P/E ratio of the S&P 500 has varied between 17 and 46.50. The average P/E during that time has been 23.44, and the high of 46.50 occurred on Dec. 31, 2001, during the heyday of the dot-com bubble. Today the P/E on the S&P 500 stands at 18.08. Thus, at least on the basis of this single measurement and recent history, the market does not appear to be overvalued.
Another use of the P/E ratio as a broad valuation method is to take its reciprocal (E/P) and view it as a “yield.” Doing this with today’s P/E of 18.08 produces an earnings yield of 5.53%. In other words, if you invest $1 in the market, you are expecting earnings of 5.53%. Comparing this yield to the yield on the 10-year U.S. Treasury note of 4.70% is a way to view the attractiveness of equities relative to bonds.
At the peak 46.50 P/E ratio, the earnings yield was 2.15%, and a Treasury note yielded 5.07%. Clearly, the broad stock market was overvalued at the time. Bonds offered better yields, and they carried almost no risk of default.
Conclusion
So how is it possible that broad stock market prices reached record levels, yet the market was reasonably valued? The key is earnings. Earnings have consistently grown at double-digit rates over a protracted period. Thus, although the numerator (Price) in the ratio was hitting new records, the denominator (Earnings) was actually growing more rapidly. With strong earnings by most companies, the market appears not to have been overvalued, even at its peak in July.