There’s a great debate on Wall Street regarding the stock market’s valuation right now. The market has soared since the historic 2009 low. Additionally, this is now the longest period in history we have not had a 5% decline in the S&P 500. That is leading many people to question whether or not the market is overvalued as we make our way into 2018.
There are many different ways to determine valuation and, for the most part, they are mostly subjective. For the scope of this article, I will be using the most common metric: The P/E ratio. On one hand, the bears argue that the stock market is overvalued and the bulls believe valuations are justified and the market has more room to rally. Let’s take a closer look:
The most common way to measure valuation is to use the price/earnings ratio (often shortened to the P/E ratio or the PER). The P/E ratio ratio looks at price vs earnings. Typically, one would take a company’s stock price and compare it to the company’s earnings per share. For the broader indices, one can take the average earnings of the components within the index to calculate the earnings side of the equation and compare it to the price.
Forward And Trailing:
The next step investors look at is to analyze forward and/or trailing earnings. Each has a different outcome. Currently, the market’s forward P/E ratio is above 19X. According to Factset, earnings growth remains strong, especially after the tax reform bill passed in December 2017.
What The Pros Are Saying:
Hedge fund billionaire, Leon Cooperman told CNBC that the stock market is not overvalued yet. Cooperman said the market is “reasonably fully valued” and because rates are low, valuations are justified here. I spoke to other portfolio managers and here is what they said:
Chad D. Roope, CFA Portfolio Manager – Fundamentum A Division of Stratos Wealth Partners, believes the market is not overvalued. He told me, “With approximately $10 in additional earnings from tax reform, the S&P 500 is trading around 18 times forward earnings. Close to where we entered 2017 (approx. 17x). While earnings are less of a concern to us currently, what investors eventually pay for these earnings is a bigger concern, especially if inflationary pressures increase. A loss of a modest 1 multiple point due to inflation concerns is an approximate 6% hit to equities alone. Without the onset of inflation, we’d expect equities to hold the multiple it has entering the year which could make 2018 another outstanding year for equity investors given the expected earnings growth. ”
James D. Hiles, ChFC and Partner, at First Capital Advisors Group, made a great point about historic P/E levels.
He told me via email, “There are more high-growth stocks in the S&P 500 than ever before and that given the tectonic shift from tangible assets on corporate balance sheets, to intangible assets, by definition P/E ratios should be higher than the historic norm. Also, if you take the S&P 500’s average P/E starting in 1990 through January of this year it is 23.85x. Currently the S&P is trading at around 18.6x forward earnings. We would also note that four companies dominate the S&P 500, accounting for 10% of the index, and trade at an average P/E of ~29x earnings skewing the P/E to the higher side.”
Not everyone is bullish. Sarah L. Jones, CIO, The Pintin Group, a private family office in Europe, is worried that the market is overvalued and the bullish trade is a crowded trade. Sarah believes that valuations are stretched and is concerned that the bullish stock market trade is getting “very crowded.”
Remember, In Bull Markets, Surprises Happen To The Upside:
If you go back and study history, this market is fully valued but not egregiously overvalued.
I would be remiss not to note that in bull markets (present market included), surprises happen to the upside, not the downside. So, just because the market is not “cheap” right now, doesn’t mean it can’t continue to rally.