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Do PE Ratios Matter?

Updated: Sep 2, 2021

"When valuations are rich, they provide more fuel for a sell-off in the presence of a negative catalyst." - Bespoke Investment Group

Markets are overvalued. Future returns will be lower. Big technology is the market. The markets are unhinged from the economy. Price to earnings multiples are through the roof.

But, does any of this matter?

At current levels, the S&P 500's price to earnings multiple is in the 99th percentile of historical readings. Rarely has the market been this expensive measured by price relative to earnings.

Source: Bespoke Investment Group

The above chart shows the trailing P/E ratio for the S&P 500 (1929-2020). The increase in stock prices (P) coupled with the fall in earnings (E) have pushed multiples to elevated levels.

A rational investor might point to elevated P/E ratios and conclude that the S&P 500 is overvalued. They would be right. That might lead us to take risk when assets are cheap and hunker down when they are expensive. Of course, we know investing doesn't work that way.

Another rational investor might decide that a fully valued market is acceptable due to the changing dynamics of the U.S. stock market and economy.

Here's why a rational investor might embrace a seemingly irrational U.S. equity market.

Price to Earnings is a Lousy Timing Tool

Expensive markets can stay expensive and vice versa. There's no other way to put it; valuation metrics are lousy timing tools. Look no further than the above trailing PE graph. The S&P has spent most of the past decade technically overvalued. An investor waiting for a more attractively valued market has missed out on massive gains.

Bespoke Investment Group tracked the PEs most similar to 2020. Returns the following year are all over the map...

Source: Bespoke Investment Group

The above graph shows years with PE ratios over 20 and S&P 500 returns for the following year. The next year returns range from -23% to +26%. There does seem to be evidence to suggest that future returns will be lower (compared to all other years), but timing is fleeting.

The above graph shows the average cumulative S&P 500 returns for investing at all-time highs (dark green) vs. any other day (puke green). This doesn't address valuations per se, but you can see that all-time highs can lead to more gains. Buy high and sell higher?

Tangible vs. Intangible Assets

Valuing a company that produces widgets is easy. Valuing a cloud-based, software as a service (SAAS) with thousands of technology patents is much tougher. Technology is by far the largest S&P sector and the value of intellectual property is almost impossible to quantify. It seems investors are willing to accept a higher multiple for the promise of future growth opportunities.

Source: Bespoke Investment Group

The above graph shows the trailing P/E ratio of the S&P 500 from 1990-2020. It's not unreasonable to use a more recent time period to reflect the modern "asset light" U.S. company. You can see the median trailing PE jumps from 15 (long-term) to ~19 (past 30 yrs).

Zero Interest Rate Policy (ZIRP)

We recently wrote about the lack of attractive investment opportunities (TINA, there is no alternative) outside of equities.

"Allocation decisions are not made in a vacuum. Rational investors are constantly evaluating the ever-changing opportunity set of available investments. In recent market pullbacks (2000 & 2008), investors had attractive risk-free alternatives to equities. In 2020, attractive opportunities to earn a risk-free real rate of return are nowhere to be found."

TINA isn't a license to load up on equities, but many investors are willing (or forced) to take risk in equities to generate a positive real return. Many point to ZIRP to justify higher equity valuations.

E Could Catch Up with P

COVID-19 caused a precipitous drop in earnings (E). Many investors and analysts are counting on earnings to normalize once the pandemic is over. If higher future earnings are realized, the PE ratio would most likely fall closer in line with historical averages.

Source: Bespoke Investment Group

The above graph shows the forward PE ratio for the S&P 500. The E represents projected or estimated earnings (trailing PE represents actual). Even based on loftier future earnings estimates, the S&P would still be overvalued. Note, analysts are historically optimistic in their future earnings estimates. We prefer using trailing valuation metrics.

Personal Circumstances

We are all playing a different game. A 25 year old probably doesn't give a rip about PE ratios (nor should they). Instead, they're focused on maximizing their savings rate. Time is on their side. They could invest in 100% equities and check out.

A pre-retiree is playing a different game (see Retiring at All-Time Highs).

Identify the game you are playing and build your portfolio accordingly.

Do PE's matter? Sure. It's important to understand the relative valuation of any asset. Can they be used to make tactical investment decisions? Not really. PE's are a futile timing tool.

By focusing exclusively on PEs, you would have likely been overly conservative much of the past decade as U.S. stocks have been technically overvalued.

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