Hardly an over-heated market

By Colin Twiggs
September 9, 2017 1:00 a.m. EDT (3:00 p.m. AEST)

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Colin Twiggs is a director of The Patient Investor Pty Ltd, an Authorised Representative (no. 1256439) of MoneySherpa Pty Limited which holds Australian Financial Services Licence No. 451289.

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Discussions as to whether the stock market is over-priced normally imply that stocks are about to fall if valuations are too high. But history shows that this isn't true. The euphoria of bull markets often outruns earnings multiples and only reverses when there is an unexpected fall in earnings.

Earnings multiples (the price-earnings ratio) may rise for two reasons:

  1. Stock prices are rising faster than earnings; or
  2. Earnings are falling and stock prices are declining at a slower rate.
S&P 500 Historic PE

The S&P 500 historic price-earnings ratio (based on the last 4 quarters earnings) spiked above 20 several times in the last three decades:

  • 1991 was caused by falling earnings;
  • 1997 by rising stock prices;
  • sharp falls in earnings were responsible for 2001 and 2008; and
  • declining earnings, particularly in the Energy sector, explain the bump in 2015.

The problem with historic PE is that it looks backward, at the last 4 quarters, rather than forward. If we take the Forward PE, based on the next 4 quarters earnings estimates, we can see that earnings are recovering.

S&P 500 Forward PE

Forward PE dipped below 20 in 2016, indicating that expected earnings are advancing faster than prices.

This does not signal a buy opportunity, which normally presents when Forward PE is close to 15:

  • 1988-1989
  • 1993-1994
  • 2002-2005
  • 2009-2012
S&P 500 and Forward PE

Nor does it represent a sell signal.

Most corporations (98.5%) have reported earnings for June 2017. Estimates are included for the remainder, giving total earnings of $27.00 per share.

S&P project that earnings will grow a further 20% over the next four quarters (Jun-18: $32.40). This may be optimistic but provided earnings grow faster than the index we will see earnings multiples decline.

S&P 500 Forward Earnings Estimates

Hardly an over-heated market.

If we become increasingly humble about how little we know, we may be more eager to search.

~ Sir John Templeton