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Why the S&P 500 Is Still a Bargain

U.S. News and World Report Smarter Investor

Based on historical data, the S&P 500 still looks attractive.

J.P. Morgan Asset Management publishes some great market research at the end of every quarter called the “Guide to the Markets.” It is chock-full of good data, but when reading the most recent issue, one page really stood out to me. The page asked a simple question: Is the S&P 500 over-bought?

No. At least not according to some data found in the guide. Here’s why:

On Dec. 31, 1996 the S&P 500 index was trading at 741. At that time, the S&P 500 had a 12-month forward price-to-earnings ratio (Fwd P/E) of 16. This is a fancy way of saying that the index (price) was 16 times (referred to as “16x”) greater than the earnings a consensus of analysts expected would be reported over the upcoming 12 months.

By March of 2000, the S&P 500 was trading at 1,527 and had a Fwd P/E of 25.6x. A P/E ratio increases because the index (price) went up, or the earnings went down. It can also be a combination of both. In this case, the index increase from 741 to 1,527 caused the P/E ratio to increase from 16x to 25.6x.

Essentially, as the P/E ratio rises, it tells investors they are paying more and more for one dollar of earnings.

Fast forward to Oct. 9, 2002. The S&P 500 index careened down 49 percent to 777 and had a Fwd P/E of 14.1x as the tech bubble burst and a recession ensued. From there it was a slow, steady march back up to an index level of 1,565 by Oct. 9, 2007—a 101 percent gain. At that point, the Fwd P/E ratio was at 15.2x. We all know what happened from there.

By March 9, 2009, the S&P 500 had lost 57 percent, bottoming out at 677 with a Fwd P/E of 10.3x. Ouch. But by Dec. 31, 2010, it had recovered to 1,258 and had a Fwd P/E of 13.1x—or an 86 percent run up. Assuming the same forward earnings as Dec. 31st, the current P/E ratio for the S&P 500 is around 13.6x.

It’s probably natural to assume that since the market has had a nice run, it’s time for it to take a “breather.” That is certainly a popular thought in the media these days. In fact, nary a day goes by where I don’t hear that message repeated over and over on TV or in print. But the current Fwd P/E is still lower than where it was during the market low in 2002. It’s also well off the most recent previous high of 15.2x.

My thought: The S&P 500, based on historical data, is not over-bought. In fact, if the forward earnings stay the same as they were at the end of 2010, the S&P 500 would have to reach 1,500 before the Fwd P/E reached 15.2x (last seen in October of 2007)—meaning there is still room to grow.

However, as I always say, if you have a complete and comprehensive financial plan driving your investment decisions (not the current S&P 500 index level or its Fwd P/E), you should be in good shape. But, if you are creating a financial plan and wondering if it’s a good time to invest or not, I think the above discussion puts things into an interesting perspective relative to what you may be hearing or reading in the press.

Twitter: @USNewsFunds

David B. Armstrong, CFA, is a managing director and co-founder of Monument Wealth Management in Alexandria, Va., a full-service wealth management firm. Monument Wealth Management is backed by LPL Financial, the independent broker-dealer and Registered Investment Advisor. David has been named one of America’s Top 100 Financial Advisors for two straight years by Registered Rep Magazine (2009 and 2010 based on assets under management) and has been interviewed by several national media sources for the past several years. David and Monument Wealth Management can be followed on their blog “Off The Wall,” their Twitter account @MonumentWealth, 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 recommendations for individuals.

Securities and financial planning offered through LPL Financial, Member FINRA/SIPC.

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