Is the Stock Market Overvalued?

Introduction

Hello, everybody. My name’s Ty Bernicke, and I’m going to be doing the October monthly market update for this month.

Is the Stock Market Overvalued?

And one of the questions we’ve been getting quite a bit lately is, is the stock market overvalued? So I wanted to touch on that. And when we talk about the stock market frequently, we’ll talk about the S&P 500 index, which is just a collective of 500 mostly U.S. large-company stocks.

Understand the P/E Ratio

And one of the things you’ve probably heard me talk about in the past is something called the P/E ratio, which stands for price divided by earnings ratio. And today I’m going to be talking about one variation of this P/E ratio called the forward P/E ratio.

So basically, again, you divide the price of the stock by the earnings of the stock or the company to come up with the P/E ratio.

If the value of the stock goes down and earnings stay stable, that P/E ratio will drop. Or if the stock price stays the same and earnings go up, that P/E ratio will drop.

Generally speaking, if you don’t understand anything that I’m saying about denominators and numerators and division and, the price-to-earnings ratio, the one thing you need to know is that lower is typically better.

Historical P/E Ratios

When we’re talking about the P/E ratio, the thirty-year average of the S&P 500 index is 17. The current average is 22.8. So again, because it’s a higher number than the historical average, historically, that hasn’t meant great things for the next five years, as we’ll show in this graph right here.

Scatterplot: P/E Ratio vs. Future Returns

So the graph that you see right here, it’s a scatterplot that shows the average rate of return as listed on the Y-axis over here.

For various P/E ratios in the past. So you can see over on the left we’ve got low P/E ratios. On the right we have high P/E ratios. And on the Y-axis, we’ve got 20% listed here. So if you see a dot at that 20%, that means that at this particular P/E ratio of approximately 12, the stock market averaged the next five years, close to 20% on average annual return.

But the biggest thing that I, the biggest reason why I wanted to show this scatterplot is that you can see on the left-hand side here, where these P/E ratios are lower, you can see that the average rate of return per year for the S&P 500 index tends to be very good, and many times over 20% on average per year.

Good. But then if you go to the right here where the P/E ratios are much higher, you can see that the average rate of return for the S&P 500 the next five years on average is close to zero, including, if you look at this red diamond, which illustrates where we’re currently at today with the P/E ratio. So

If you were to look at this in isolation, you would think, gosh, that’s kind of scary because that would imply not good things going forward in the future.

The Role of Artificial Intelligence

But the reason that we’re not as concerned today as we might have been in the past with this high of a P/E ratio is what I would call the big unknown, which is how much efficiency is artificial intelligence going to add to corporations in the future? Because most people know that’s been involved with business planning in any sort of situation that most companies’ biggest expense is labor.

And it’s also been talked about how artificial intelligence will help many companies reduce labor, therefore reduce their biggest costs, which therefore should improve earnings. And again, if earnings improve, that helps to drop that P/E ratio.

So the reason I’m not as alarmed by the P/E ratio today as I would have been in the past, is because of the advent of artificial intelligence.

If it’s going to be half as big as what many people are talking about, that should improve that P/E ratio and make it better for the market to be able to buck the trend of having a higher P/E ratio, as illustrated in that scatterplot we had just shown.

Other Considerations

But there are a few other considerations to think about too.

If you look at the S&P 500 today and you just take out the ten biggest companies and keep the remaining 490 companies in the S&P 500 index, that actually drops that P/E ratio down considerably. Number one. Number two, we just talked about large-company stocks as measured by the S&P 500 index. Most of you also own small-company stocks and international stocks, and both small-company stocks and international stocks, I would argue, have more favorable P/E ratios than U.S. large-company stocks today.

So for all of these reasons, I wouldn’t panic about the current state of the P/E ratio. Certainly, you can find any sort of news out there right now to justify your opinion on where the markets are, whether you think they’re overvalued or undervalued. You can get any opinion you want out there. But that’s our stance on things today.

Current Market Stance

So we’re not making any big decisions or changes with portfolios at the present time. For all the reasons that I just mentioned.

I hopefully gave you an understanding of kind of where we’re thinking the markets are. Of course, in this business, there are always things percolating under the surface that you can’t see that could potentially come back to bite us, but at the present time, you know, we’re kind of in a pretty neutral state of mind as far as where the market is valued at.

If you have any questions or concerns, please feel free to reach out to us. And, hope you learned something valuable today at the monthly market update. Thank you.