It’s a question that many of our clients have asked us as the stock market continues to hit new highs seemingly every day. And one that we hope to explain in this video. We discovered a fascinating chart that we think describes why the stock market is holding up or goes higher even when there’s mediocre economic news.
There are many methods of measuring the value of a stock, but the most prominent is something called the PE ratio or price to earnings ratio. It’s simply the price per share of the stock divided by the earnings per share. As an example, let’s look at Coca Cola which is trading around $40 per share with earnings of $2 per share over the past 12 months. It’s trading at a PE of 20. So is a PE of 20 expensive or cheap? On its own, we really can’t tell. We need to compare that PE to other things like similar companies, (Pepsi) or to its own historical PEs, or even to the PE of the entire stock market. Based on those comparisons, we can determine how expensive or cheap Coca Cola is today.
To decide whether the stock market is expensive or cheap, we took a look at the PE of the S&P 500 going back 43 years and compared this to the 10-year Treasury rate. In doing this, we discovered a fascinating phenomenon that’s occurred during the last 3 years. The Federal Reserve’s involvement in keeping interest rates artificially low has had an interesting effect on the value of the stock market. So is the stock market too expensive?Full Transcript
>> Hi I’m Barry Glassman. Today I want to dive into stock market valuation for sure, but I also wanted to show you a chart that we came up with that I think explains why the stock market holds up so well even when there’s mediocre or bad economic news. So as far as stock market valuation, people use all kinds of different measures, but the most prominent one is something called the price to earnings ratio, and I wanted to get through a brief explanation of this quickly and then we’ll get to our fascinating charts. The PE ratio, or the price to earnings ratio is the price per share divided by the earnings per share for either a company or an entire stock market. So as an example we can do this for Coca-Cola which is trading at about $40 a share today. The past 12 months it had $2 of earnings per share. It’s trading at a PE of 20. Now is 20 deemed expensive or cheap? We don’t use 20 and say that it’s expensive or cheap. The way we use PE ratios is to compare it to other things. We can compare it to other companies in the same space. So for example the PE of Pepsi may be meaningful in comparison. We may compare it to the overall stock market to show that Coca-Cola’s trading expensively or cheaply compared to the overall stock market. Or we can use this ratio to compare it to Coca-Cola over the past 40 years. So maybe given its history it’s trading at the highest or lowest multiple that it’s ever traded at. So we can certainly do this for stocks. We can also do it for entire stock markets. This shows the S & P 500 and the historical price to earnings ratio going back 43 years. Now what you’ll find is that there are trends in here where, for example, in the 70’s and early 80’s, PEs were trading around 10 and even into the single digits. We haven’t seen those lows in the last 20 years or so. They’ve been trading much into the double digits with peaks coming during the tech boom in Boston, another one during the financial crisis. In today’s PE it’s trading at somewhere around 18. And part of me wants to, part of all of us wants to take that 18 and compare it to past times when it was trading at 14 or 20 or the average which is somewhere around 16 or 17. I think that we need to bring in another variable and that’s where we came up with this chart. What this chart shows is the PE ratio for each year compared to the 10 year treasury of that corresponding year. So walking through this chart we’ve got the, on the left side we’ve got the 10 year treasury rate going very low to high, and then the PE ratio across the bottom. Now what I’d like to do is just, I want to take out the two extremes of the tech bubble and the financial crisis just to show you some trends. I’m also going to take out, when you see this next chart, I’m taking out the past three years as well. I’ll add those in in a moment. And what we’ve found, and you’ll see this a bit more closely once I put these bands in, is that the higher the interest rate environment, the lower the price to earnings ratio. So when interest rates are around 12 or 10 or so, the PEs were somewhere around 10. When treasuries were yielding much lower, let’s say 4 to 6%, it justified a much higher PE. Now there are a couple of reasons for this. We wanted, we don’t want to just present the chart and leave you to digest this yourself. Some reasons some people may say that well corporations are able to borrow at cheaper rates so that it can lever up growth and so forth, and that’s certainly something. But also I think the most simple explanation is that when treasuries are yielding 10 or 12% as a risk free rate of return for a 10 year period, it’s hard to justify overpaying for stocks at that time and boosting up stock prices. But when PEs are really low– I’m sorry when interest rates are really low treasuries are yielding 4 or 5%, certainly it justifies taking a bit more risk to shoot for stock market returns. Now this would be fascinating in and of itself, but when we put in the last three years shown here in yellow, what you’ll find is that we fall outside of this band. We’re down not only in interest rates but you know the PEs aren’t following. And why is this? Well a couple of things. Number one is, firstly, if today’s interest rates justified a PE, we’re looking at probably the cheapest stock market we’ve ever seen in the history of the stock market. Or at least for the last 43 years. But this is also why in spite of a slow growing economy, high unemployment and congress, the stock market it keeps going higher. You see the longer the federal reserve stays involved, the lower interest rates will be for a longer period of time. And based on our illustration and our math, it justifies stock prices if not even a little bit higher. But no one believes that today’s interest rates are real. They’re definitely artificial. So we need to do some guess work, and if we believe that interest rates should be much, much higher, stock price may be, stock market may be overvalued. It really depends on where we believe interest rates should be. I hope this gives you some perspective on stock market valuation and really why when economic news isn’t so good, stock market holds up pretty well.
If you have questions, feel free to give us a call.