Investor Psychology

Just How Pricey Is This Stock Market?

Let’s put the S&P 500’s P/E ratios under a magnifying glass.

Even with this year’s surging corporate profits, the Standard & Poor’s 500-stock index is trading at historically sky-high price-to-earnings ratios. Many “experts” seem to agree that the stock market is monstrously overpriced.

But maybe it’s not.

Let’s look at P/E ratios and see where we really are. Price-to-earnings, for the uninitiated, is simply a stock’s share price divided by its earnings per share. This ratio provides a straightforward measure of how cheap or dear stocks are. But the confusion starts because there are several different varieties of P/E ratios.

Start With the Shiller P/E

Conceived by Nobel economist Robert Shiller, it calculates the market’s P/E based on the average of inflation-adjusted earnings over the past 10 years. Shiller, a Yale professor, calls this a cyclically adjusted P/E (CAPE) ratio because it smooths out the peaks and valleys in earnings during the economic cycle.

The Shiller P/E is currently 32.3. That’s slightly lower than the record high of 33.2 set in January since at least 1880 (when Shiller’s records begin), with one exception: the tech bubble in 2000. And we all know how that movie turned out. In December 1999, the Shiller P/E crested at 44.2. Before the 1929 crash, it hit a high of 30. The median Shiller P/E is 17 — about half current levels. That, in a vacuum, suggests a 50% bear market is at least possible.

Just one problem: The Shiller P/E has been flashing “Sell!” without interruption since the early 1990s, except for a brief period at the end of the 2007-09 bear market. Critics also argue that S&P 500 earnings during the 2007-09 selloff were so depressed that they still distort the current Shiller P/E readings.

Forward and Trailing Operating Earnings

Most professional stock pickers look at P/Es based on the consensus of analysts’ estimates of operating earnings for the coming 12 months (known as forward earnings). That forward P/E for the S&P 500 stands at 16.9; since 2000, which is as far back as forward P/Es have been calculated, the average has been 15.9 – about 6% lower from today’s reading.

We can look a little rather back via operating earnings for the preceding 12 months (trailing earnings). The S&P 500 trades at 19.3 times trailing operating earnings. Since 1988, the average P/E on trailing earnings has been 17.4 — or 11% lower than today.

But there’s a problem with P/Es based on operating earnings. Although they’re valuable for stockpickers, operating earnings exclude all manner of “one-time charges.” Critics sometimes describe operating earnings as “earnings before bad stuff” – of course, sometimes a company can benefit from one-time boosts to earnings, too. And while they might be outliers, they still very much contribute (or detract from) companies’ actual profitability.

GAAP Earnings

A perhaps fairer way to look at the stock market is to examine earnings computed using generally accepted accounting principles (GAAP). On GAAP earnings, the S&P currently changes hands at 22.8 times trailing earnings. GAAP earnings also have the benefit of being calculated, albeit with changes in the standards, since 1946. The average P/E since then has been 16.7. That’s a whopping 36% lower than they are today.

So, the stock market is just modestly overpriced using operating earnings and very overpriced using trailing GAAP earnings.

In my view, trailing GAAP earnings give the clearest picture of how much the stock market is paying for a dollar’s worth of earnings.

But there’s one more factor to consider, says Sam Stovall, chief investment strategist for CFRA Research: inflation. When inflation has been higher, P/Es have tended to be lower and vice versa.

Inflation today is rising but still is at a relatively low level, roughly 2.3%. “Inflation and price-to-earnings ratios are like an old-fashioned scale,” Stovall says. “Normally when inflation levels are this low, P/Es are high. As inflation creeps up, P/Es decline.”

When inflation, as measured by the core consumer price index, has been 2.3% since 1957, the market’s P/E based on trailing GAAP earnings has averaged 24. That turns out to be just about where we are today.

It makes sense to me to include inflation in P/E calculations. The lower the rate of inflation (and interest rates), the higher future corporate earnings per share are likely to be. The problem for investors today is that inflation is rising, which ultimately should spark a market selloff. But for now, relatively low inflation tells me that the stock market’s P/E ratio isn’t flashing any danger signals.

Steve Goldberg is an investment adviser in the Washington, D.C., area.

Most Popular

5 Ways to Prepare for a Recession
recession

5 Ways to Prepare for a Recession

The signs seem to be pointing in one direction these days, so if you’re worried about being ready for a recession, consider taking these five measures…
June 28, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
In What Order Should You Tap Your Retirement Funds?
retirement planning

In What Order Should You Tap Your Retirement Funds?

Should you go with your IRA first or your brokerage account? Pulling money haphazardly can have negative implications. Instead follow this road map fo…
June 28, 2022

Recommended

Is the Stock Market Closed for the Fourth of July in 2022?
Markets

Is the Stock Market Closed for the Fourth of July in 2022?

Independence Day falls on a Monday in 2022, so the bond and stock markets will enjoy a long holiday weekend. Here's a look at the markets' holiday hou…
July 1, 2022
Top Bear Market Tips from 10 Financial Advisers
investing

Top Bear Market Tips from 10 Financial Advisers

When a bull market turns into a bear market, it can be hard to know what to do. Take comfort in the guidance of 10 financial professionals.
June 30, 2022
Move Over ETFs: Direct Indexing Is an Investment Strategy Worth Paying Attention to
investing

Move Over ETFs: Direct Indexing Is an Investment Strategy Worth Paying Attention to

More flexibility, more control, the potential for higher returns and tax-reducing strategies: With pros like that, could direct indexing be right for …
June 25, 2022
Smart Investing in a Bear Market
investing

Smart Investing in a Bear Market

Here's how to make the most of today’s dicey market.
June 22, 2022