The P/E and Client PessimismAdvice to the Advisor
Investors have become used to keeping their eye on the price earnings ratio of their pet stocks. In fact, the P/E is a useful way to evaluate the attractiveness of a company’s stock price compared to its current earnings per share. As observers of the market, we also know the truth of Josh Kennan’s observation in thebalance.com: “One potential way to know when a sector or industry is overpriced is when the average p/e ratio of all of the companies in that sector or industry climb far above the historical average.”
The P/E ratio can be used by investors to:
- determine which industries and sectors are overpriced or underpriced
- compare the prices of companies in the same area of the economy
- judge the general sentiment in the stock market
It’s this last use that has come under recent discussion (and about which you’re likely to be fielding client questions). “With stock indices close to all-time highs and unprecedented monetary stimulus in recent years, it is reasonable to ask whether the US economy has reached a potentially dangerous phase of excessive financial exuberance and of overvaluation in the stock market in particular,” William Cline writes in the Peterson Institute for International Economics blog. In other words, are P/E ratios “stretched” to the point of snapping back?
Earnings, we see from the chart shown below, are certainly at record highs.
But, as Sheaff Brock Managing Director Dave Gilreath emphasizes in April’s Knowledge Builder webinar, high earnings do not mean Price Earnings Ratios are over-stretched. In fact, Gilreath points out, in every decade since the 1920s, the average PE ratio for the Standard and Poor’s 500 Index has been 17, precisely where we are today!
“The standard way to investigate market valuation is to study the historic Price-to-Earnings ratio using reported earnings for the trailing twelve months,” writes Jill Mislinki in Advisor Perspectives, Inc. But looking at Yardeni.com’s chart of forward earnings, Dave Gilreath explains, the S&P 500 earnings estimates of $174 x P/E of 17 = a Standard & Poor 500 level of 3,000!
Advisors might find this information reassuring to their clients. Perhaps, after all, the Price/Earnings might prove mightier than the pessimism!