Want to know how the market feels about the future? Have a look at how much investors are willing to pay for a dollar of profits1. That’s the price-to-earnings ratio. It’s simply the stock price divided by the company’s earnings per share. A stock that has reported $2 per share in earnings over the past year and is trading at $40 has a P/E ratio of 20 to 1. We usually just shorten that to a PE of 20. Looking at it a different way, that means buyers at the current price are willing to wait 20 years to get back their investment.
Obviously, that would be nuts. The usual reason a PE ratio would be that high is because investors expect the company’s profits to increase. If that $2 profit doubles, then if the stock is still trading at $40, the PE ratio drops to 10. But if the market is still hot on that stock and it’s still willing to pay 20 times the past year’s profits, then the stock price doubles. If the market doesn’t expect much growth, it wouldn’t be willing to pay such a high multiple of past earnings.
What strikes me today is how high the PE multiple is for the overall market these days. As I write this, the PE of the S&P 500 index—which measures the weighted average of all the stocks in the index—is close to 292 when the average PE for the index over the past 20 years was closer to 253. There are two entirely different ways to interpret that high PE. The first is that the market understands earnings will be temporarily low because of the pandemic and, when profits recover, stocks will once again be fairly priced. The other is that we’re more optimistic about the economy today than usual.
I suspect we’re in the midst of an optimistic market, or maybe a better way to put it is the market has pessimism fatigue. For example, Carnival Corporation, those purveyors of floating buffets, reported earnings and sales close to half below expectations4, but the stock has actually been trending higher5 since the beginning of August. Granted, the firm has also been shrinking itself for a new level of demand, so it’s not the same company as it was pre-pandemic, but I still see investors are increasingly optimistic about Carnival’s recovery.
Sooner or later, we will move on from the pandemic. The question is how long it will take and the price we’ll have to pay. Should market sentiment get gloomy again, those relatively high PE multiples will recede. “Receding multiples” is usually a euphemism for stock prices falling.
Over time, markets are efficient, so I’m not going to recommend drastic changes. But the market isn’t throwing away the baby with the bathwater as it was in the early days of the pandemic.
Evan R. Guido is the Founder of Aksala Wealth Advisors LLC, a 2018 Forbes Next-Gen Advisors List Member, and Financial Professional at Avantax Investment ServicesSM. Evan heads a team of retirement transition strategists for clients who consider themselves the “Millionaire Next Door.” He can be reached at 941-500-5122 or firstname.lastname@example.org. Read more of his insights at https://finance.heraldtribune.com/category/ask-guido/. Securities offered through Avantax Investment ServicesSM, Member FINRA, SIPC. Investment advisory services offered through Avantax Advisory ServicesSM, Insurance services offered through an Avantax affiliated insurance agency. 8225 Natures Way Suite 119, Lakewood Ranch, FL 34202. The views and opinions presented in this article are those of Evan R. Guido and not of Avantax Wealth ManagementSM or its subsidiaries. Past performance does not guarantee future results. The S&P 500® Index is an unmanaged index of 500 selected common stocks, most of which are listed on the New York Stock Exchange. The Index is adjusted for dividends, weighted toward stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. Investments cannot be made directly in an index.