Stocks are in a bind right now. Earnings have come through very well, but share prices are stagnant. The end result? The S&P 500 is cheaper than it was late last year in terms of valuation.
There are different methods to value stocks, but perhaps the most common method is based on the price/earnings ratio. That is the price of a given company’s shares divided by the company’s earnings. We can also look at the average P/E ratio for the S&P 500 stocks.
Estimates of future earnings for stocks are notoriously unreliable so I believe it is better to use trailing earnings as used in the chart below. This chart gives the recent trend for the S&P 500’s average P/E:
Source: Bespoke Investment Group
The red line shows the price trend since June of 2009. Prices peaked a few months ago when the correction began. However, corporate earnings have been grown since then. As earnings (the E in the P/E ratio) rose, prices (the P in P/E) fell. So the net result has been much lower valuations based on the P/E ratio, which is currently in the 15 range.
At this level, stocks are attractive although we are still not at the historical low end of the P/E range, which is with average P/Es in single digits. However, that level was last reached in the early 1980s when interest rates on Treasuries were four or five times higher than they are today.
This chart from my firm illustrates just how high Treasury bond yields were back in the early 1980s when P/E ratios last bottomed out:
Source: Brouwer & Janachowski, LLC
Treasury yields peaked in late 1981, but they remained in double digits for years. Higher interest rates made stocks less attractive back then. Why buy stocks when you could get 15% yields?
Now, we are in a very different environment. long-term Treasury yields are around 4%. Yields could go lower if the economy tanks, but stock prices are attractive. They have the potential for capital appreciation plus many have decent dividends, which tend to grow over time.
The dividend yield for the S&P 500 is about 2% now. This is low by historical standards, but compares favorably to current yields on Treasuries. For example, 2-year Treasuries yield 0.55%, 10-year Treasuries yield 2.91% and 30-year Treasuries yield 3.98%. In my view, with reasonable P/Es and decent dividends, stocks look to be attractively-priced for patient, long-term investors.
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Kurt ~
I always love your concluding sentences; but, again, I would have added one ‘little’ addtional phrase:
“In my view . . . attractively-priced for patient long-term investors,” . . . UNLESS BOTH HOUSES IN CONGRESS REMAIN IN THE HANDS OF THE DEMOCRATS.
Kurt Brouwer is a fee-only financial advisor with three decades of experience. He is the chairman and co-founder of Brouwer & Janachowski, LLC. Kurt has written books, articles and hundreds of blog posts on mutual funds, ETFs and other investment topics. E-mail: kurt.brouwer *at* gmail.com.
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