Five and a half years into a bull market, the bears are eager to argue that today’s market is overvalued. Of course, many of them have been saying that for 5 1/2 years, but that’s another story.
I have not been in the “market is overvalued” camp.
But this week, while working on a course I’m developing for Investment U, I was reminded of how much valuations have increased over the last three years. For example, the price-to-earnings ratio (P/E) of the S&P 500 rose from 13.6 in 2011 to 17.8 today – a 31% increase.
[ad#Google Adsense 336×280-IA]So it isn’t just that stocks have risen on record earnings.
The higher P/E ratio tells us the amount we’re willing to pay for those earnings has climbed as well.
Keep in mind that at the end of 2011, we were only 2 1/2 years from the bottom of the market, during what was a near economic collapse.
At that time, the economy still hadn’t gained much traction.
We were no longer in fear of financial Armageddon, but things weren’t exactly rosy.
As 2011 closed, unemployment was still 8.5%, so it makes sense that stocks would still have been discounted, even though we were in a bull market.
A Closer Look
With the S&P 500 hitting record highs this week and breaking 2,000 for the first time, I decided to dig even deeper. I took a look at where valuations are now compared to the end of 2011, and compared them to market tops in 2007 and 2000, as well as their 10- and 20-year averages.
There’s no doubt we’re paying a lot more for earnings than we did in 2011. I mentioned the S&P’s figures earlier. The Dow Jones Industrials’ P/E is 23.5% higher and the Nasdaq’s is 49.1% higher.
Price-to-book value (P/B) is also higher now than in 2011. Book value is essentially the net worth of a company. Price-to-book value is similar to P/E, but instead of seeing how many times earnings per share a stock trades for, you’re seeing how many times its book value per share trades for. If a stock has a book value of $10 per share and it trades for $15, it is trading for 1.5 times its book value – a P/B of 1.5.
The P/B of the S&P 500 is 33.1% higher than it was in late 2011.The same metric for the Dow is up 11%, and the Nasdaq is 42% richer.
So in comparing valuations today with 2011, it’s easy to see why some people think this market is overbought.
But that’s a distorted view. A more accurate reading requires a broader perspective.
And when we compare the current market with the market top in 2007, we find that most of the valuations from the major indexes are today well below those levels.
Only the P/E of the S&P 500 is higher today than it was in 2007, and by only 2.8%. All of the other key valuation metrics – for the S&P, Dow and Nasdaq – are today still well below what they were at the 2007 market top.
Looking for a bargain? Consider stocks in the banking sector. Those stocks are trading 29.8% lower than the 2007 top on a P/B basis. And the group is trading significantly lower than its 10- and 20-year averages.
Some of the most heavily weighted components of the index include Bank of America (NYSE: BAC), Citigroup (NYSE: C) and JPMorgan Chase (NYSE: JPM).
On an earnings basis, the most overvalued sector, compared to the top in 2007 and its 10-year average, is telecom. The P/E is 187.9% higher today than in 2007 and 123.9% above its 10-year average.
Stocks in the telecom index include Telecom and Data Systems (NYSE: TDS), CenturyLink (NYSE: CTL) and American Tower Corp. (NYSE: AMT).
There’s no doubt, even as companies are growing their earnings, that investors are willing to pay more for those earnings than they were a few years ago. However, it makes sense to look at other valuation metrics such as price-to-book and to compare valuations to other periods. When looking at the most recent top or 10-year averages, it appears that there is plenty more room for stocks to appreciate.
Good investing,
Marc
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Source: Investment U