How to Value the Stock Market
The S&P 500 is on the undervalued side and has significant room for growth.
In a headline-driven environment, it’s easy to get confused about which way the market is moving. Let’s put aside the calamities of the day and focus on the fundamentals of “the market,” as defined by the Standard and Poor’s 500 Index (S&P 500). The S&P 500, which includes the 500 largest companies in the U.S., represents more than 80 percent of the U.S. stock market and is widely regarded as the best single gauge of the U.S. stock market.
Two powerful measurements for determining stock valuations are price-to-earnings ratio (P/E) and earnings yield (E/P). In fact, earnings and earnings estimates have more to do with the movement of stock prices than any other measure. In 2010, the earnings for the S&P 500 came in at $83.77. According to Standard & Poor’s, the earnings estimates for 2011 are at $97.81 and $111.73 for 2012. Both are at historic highs and have been revised upwards in the past six months. Assuming that these estimates hold, we can use this data to compare our current findings against historical results.
The P/E ratios of the S&P 500 from 1988 to today range from a high of 29.44 in the fourth quarter of 2001 to a low of 11.51 posted in the fourth quarter of 1988. Eliminate the extremes, and you come away with averages that fall between 13x and 16x earnings. As of July 1, 2011, the S&P 500’s current P/E is 13.65 (using the S&P 500 July 1 price of 1335 and a 2011 earnings estimate of $97.81). If you use the 2012 earnings estimate, you end up at 11.95x earnings. As you can see, we are much closer to the historical low end than the high end whether we use the 2011 or 2012 estimates—which indicates that the markets are on the undervalued side and have significant room for growth.
Now, let’s take a look at earnings yield, which is defined as earnings/price. If we use the same 2011 S&P 500 earnings estimate of $97.81 and an S&P price of 1335 (97.81/1335), you come away with a multiple of .073 or 7.3 percent. Simply put, this means that the expected earnings of the S&P 500 are 7.3 percent of the price of the index. Why is this relevant? Because we are comparing the additional rate of return we expect to receive by investing in equities with the anticipated rate of return offered by other asset classes.
We can also compare these returns to the rate of inflation. Over the past 50 years, the average earnings yield for the S&P 500 has outpaced inflation by 2.4 percent. When the market is above that mark, equities are generally considered attractive. When below that mark, stocks may be considered expensive. If we subtract the current core inflation rate of 1.5 percent from the 2011 S&P 500 earnings estimate of 7.3 percent, we end up with 5.8 percent—well above the 50-year 2.4 percent level. Even if we use the 3.4 percent consumer price index rate, we come out at 3.9 percent (7.3 percent minus 3.4 percent), which is still a very attractive number when compared to most interest-bearing investments. A look at history shows that the last time the S&P 500 earnings yield approached 7 percent was at the end of 1994. The market enjoyed a nice five-year run from there. While it’s not the perfect indicator, when combined with the P/E ratio, earnings yield can provide a useful point of reference.
Earnings and earnings estimates play an important role in market dynamics. We just finished the second quarter and will soon find out how just how solid those estimates are. If the companies hit their earnings targets that’s good news, but more important is the guidance they give for the future. The markets will put more emphasis on future earnings expectations than how well they did last quarter. That’s history.
Timothy S. MicKey , CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall , on Twitter at @MonumentWealth and @TimothySMickey, and on their Facebook page. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results. Strategies involving asset allocation and diversification do not ensure a profit or protect against a loss.
Read this article on U.S. News & World Report >>
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Monument Capital Management, LLC [“Monument”]), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Monument. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. No amount of prior experience or success should be construed that a certain level of results or satisfaction will be achieved if Monument is engaged, or continues to be engaged, to provide investment advisory services. Monument is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.
A copy of Monument’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or at www.monumentwealthmanagement.com/disclosures. Please Note: Monument does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Monument’s website or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your Monument account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your Monument accounts; and, (3) a description of each comparative benchmark/index is available upon request.
Please Remember: If you are a Monument client, please contact Monument, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Please Also Remember to advise us if you have not been receiving account statements (at least quarterly) from the account custodian.