The Value of the P/E Ratio

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There are certain points in my writing for MCM when I encourage readers to take a second look at the risk in their investment portfolio. By proactively managing equity and interest rate risk, investors may be able to decrease the level of volatility in their portfolio. First, a quick lesson in financial risk definitions:

  1. Equity Risk: This is the risk involved in holding a particular equity, also often referred to as stock in a company.
  2. Interest Rate Risk: Your bond investment will go down when and if interest rates go up.
  3. Inflation Risk: There is a risk that your money will not be able to purchase as much in the future as it currently can; therefore, making your future money less valuable.
  4. Systematic Market Risk: For investors who are involved in different capital markets, this type of risk often cannot be mitigated through diversification.

When looking at the stock market’s risk/reward as a foundation of our analysis, we look at the price/earnings ratio, also known as the P/E. This gives us a good basis for determining whether the market is fairly-priced based on past market conditions. Marcrotrends.net shows that over the last 90 years, the historical P/E ratio of the S&P 500 index has been approximately 15.9. (That statistic is also provided at mutipl.com.) Anything significantly above that number could be interpreted as an “overvalued” market; anything below that number could be “undervalued” on a historically relative basis. As a frame of reference: during the 2000 era dotcom bubble, the S&P 500 made an all-time high of approximately 45. The heavily-weighted NASDAQ ended up declining by roughly 75% over the next three years. As of this writing, the S&P 500 P/E ratio is 44.34. When the historical average is 15.9 and we are ringing in at 44+, investors may be well advised to take a second look at the amount of risk to which they are currently exposed.

There are many different reasons why the markets are trading at such a high-earnings multiple. One is government intervention into our capital markets system. When you give cruise lines, airlines and Boeing guaranteed low interest rate loans to survive, you almost certainly take the risk of bankruptcy off the table. Due to government regulations, cruise lines in the U.S. haven’t had a domestic cruise set sail for over a year! Our government has truly thrown off the risk vs. reward scale, and I believe that is one of the largest reasons why the stock market is trading so high and at such a high multiple of earnings.

Now, I’m not saying that the sky is falling or the world is ending. All I’m saying is that I believe the stock market’s P/E ratio will eventually return to the average of around 16. Either corporate earnings have to increase significantly or stock prices have to fall significantly, or a mixture of the two. At this point, there are significant levels of all the above-listed risks in our capital markets. I would encourage MCM readers to have their advisors do a full-scale risk analysis to determine whether their portfolios are designed around individual personal risk tolerance. If you have not done this recently or don’t work with a financial advisor, advisors at OLV Investment Group would be happy to walk you through the process.

 

 

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