- Along with stocks' gains, some traditional stock valuation metrics are now quickly approaching long-term averages.
- The S&P 500 traded last week at around 15 times reported earnings, closing in on the average trailing P/E of 17 for the last 25 years.
- Investors fear a high P/E signals a stock is overpriced. But market valuations don't mean much on their own—compared to long-term government debt, stocks are attractively cheap even at average P/Es.
- A fast and furious climb doesn't mean this is a "sucker's rally" or that the market needs to "take a breather."
(Editor's Note: MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.)
Markets have been on a turbo-charged tear the last two months, with the S&P 500 surging almost 40% since March 9th. But in the wake of exhaust fumes and echoes of peeling rubber, some investors are questioning this rally's stamina looking ahead.
Along with stocks' gains, some traditional stock valuation metrics like the price-to-earnings (P/E) ratio are now quickly approaching long-term averages—raising investor concerns about the market recovery moving too fast. The average trailing P/E for the last 25 years is 17—and at the end of last week, the S&P 500 traded around 15 times reported earnings, the highest since last October and up from 10.5 in February.
Rising P/Es indicate companies' stock prices are ascending higher relative to earnings. If prices are proportionally much greater than earnings, investors fear stocks must be overpriced with limited upside or, worse, prices must decline. However, contrary to popular belief, P/E levels aren't predictive of future market returns. A high P/E doesn't necessarily signal stocks are expensive or a period of subpar returns must follow. Market valuation measures like the P/E ratio don't mean much on their own. They're most effective when compared to other viable investment options, like bonds. A quick and easy way to compare stock valuations to bonds is to turn a P/E ratio on its head to get the E/P—better known as the earnings yield. Aggregate market earnings yields and bond yields are usually pretty close, but today, stocks' E/P is way above the yield on long-term government debt. With interest rates on long-term Treasuries exceptionally low, stocks are attractively cheap even at average P/Es. This doesn't mean stocks must run up immediately to bring the two yields to parity, but it does mean stock prices have a long way to go before stock valuations could put brakes on stock returns.
On Monday, to help fund a stock buyback and investments, Microsoft announced its first bond offering in the firm's 34-year history—in part to capitalize on these attractive stock valuations. The AAA-rated Tech behemoth will sell a total of $3.75 billion in 5-, 10-, and 30-year bonds, despite the fact it already has $25 billion in cash and short-term investments. Microsoft's 10-year bonds are expected to pay 1.05% over comparable Treasuries, or about 4.2% at current rates. That's an after-tax cost of less than 3%. The forward P/E on Microsoft stocks is 11.3 for an E/P of 8.8%. So the firm can borrow money cheaply and immediately boost its bottom line by buying back its own shares!
Plus, forward-looking stock market valuations probably aren't as rich as many investors believe due to overly dour earnings expectations. For Q1, the 87% of S&P 500 firms who reported earnings (as of May11th) collectively beat analyst expectations by +9.5%—the best reading ever (and highest since Q1 1988's +8.0% upside surprise). If first quarter earnings are any indication, future earnings could be considerably better than most analysts expect.
A fast and furious climb doesn't mean this is a "sucker's rally" or that the market needs to "take a breather." Markets can rapidly gain a lot of ground—especially during the initial thrust of new bull markets. We won't know with certainty if March 9th represented the bottom of the bear market until we're well into a new bull market, and markets will still dip now and then, shaking nervous investors out. But those fearing high speeds will likely miss the new bull market, at the expense of catching their breath.