If you’ve been around for a minute, you’ll know that as investors, we pay close attention to the overall market valuation and the valuation of individual stocks compared to their industry average.
The price-to-earnings ratio—one of the most common valuation measures—shows you how much you are paying for every dollar of earnings a company makes. The long-term average P/E for the overall market is 16.57, meaning you pay $16.57 for every dollar in earnings a company generates.
Looking at the market as a whole today, as represented by the S&P 500, the average P/E is 18.4—still above the long-term average. That is why we’re saying the market still looks expensive. Granted, before the coronavirus crisis started, the average P/E was slightly above 22, so we did see a drop. At its lowest point, the market’s P/E was around 14—still not that far below the long-term average. Furthermore, the market has regained a little more than 25% from the bottom we saw on March 23, 2020.
So that’s a lot of numbers—what does it mean? To us, it appears that the market is looking through our current situation. We currently have close to 18% unemployment, thanks to companies filing on behalf of furloughed employees and those who have been unable to work because of social distancing. Earnings are also falling apart. Most of our economy is service-oriented, so with many businesses and stores closed, it’s not surprising that company earnings are suffering.
Often the P/E you see quoted will be a forward P/E, which simply uses future estimated earnings for the next 12 months. Our forward P/E is around 21.07. This could indicate that the economic recovery will happen quicker than we initially thought. Quite literally, the market is looking beyond our current crisis. We haven’t seen a forward P/E this high since the Tech bubble of 2000. Even through the Great Recession of 2009, the market was not this expensive. Temper that with how ridiculously low interest rates are. Low interest rates tend to increase the profitability of companies. Of course, that is no guarantee the market won’t drop 30%. How do you even begin to predict what will happen?
The reality is you can’t. This is why it is so important for investors to have 10 years of liquid assets to cover their spending. Long term, we’re confident that the stock market will outperform other asset classes, so it is the best place for growing your long-term money. Despite the current crisis, the S&P’s current dividend is 2.1%. Even if the market were to stay flat for the next quarter or two, you could still make money with dividends, which are significantly higher than current interest rates.
Predicting the market is a fool’s game. No one could have predicted 2019 would finish the year up 31.4% when we had just come off fourth quarter 2019, having lost nearly 20%. Likewise, no one could predict a pandemic that would force our economy to a screeching halt. Therefore, we will always recommend keeping your short-term money safe and investing only long-term assets that can weather the inherent volatility of the stock market.
If you have questions regarding applying our Ten Year Rule to your money, the experts at Henssler Financial will be glad to help: