Understanding the Market: The S&P 500 is Cheaper Than in 2015/2016 — July 9, 2017
Headlines and the financial media are again selling the risks posed by high valuations.
The simplest perspective on the expense of the market, and probably the broadest, is the price-to-earnings ratio.
It’s important to note that high valuations do not imply or cause bear markets – rather they imply lower expected returns. It’s like buying model houses in a tract neighborhood: pay $50,000 more than your neighbor for the same house and you are highly likely to see a lower rate of return on your purchase than the neighbor that paid $50k less.
The market is no different. The best returns come from buying when the market is undervalued, the weakest from the market is overvalued.
Right now, the S&P is very pricey. But earnings are rising again, which is one of the reasons the S&P has become less expensive by this ratio that it was in 2015/2016. Earnings are trending up and have moved above the 2014 EPS high.
Where is the S&P’s Price-to-Earnings ratio right now?
*Negative P/E ratios have been set to zero.
It’s easy to see that rising earnings have pushed down the valuations we saw in 2015/2016.
Current Fair Value for the S&P 500 is about $2060, nearly -15% below Friday’s close price.
While a 15% premium does not constitute a bubble or an extraordinary investment risk, it does tell investors it may be worth it to look for better opportunities (better expected returns/higher margin of safety) away from the broad market index.
2nd quarter earnings are fair so far, with a few exceptions, and this trend looks like it will continue into Q4.
The Fed raised rates at the most recent meeting, but we are still well below historical average interest rates.
All in all, it’s not a great investment environment, but neither is it terrible. The economy is likely to keep muddling along. Low interested rates combined with rising earnings will help drive the markets higher, given time. But with the S&P so pricey, sector focused investments are probably a better bet.
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Process Portfolios, LLC.