The average investing portfolio has had a good run, with the stock market up about 9% this year and 271% since the current bull market began all the way back in 2009.
It can’t last much longer, many investors believe. Money managers fret about high stock-market valuations and the downfall that often follows them. The price-to-earnings ratio for the S&P 500 index sits at 23.6, significantly higher than the long-term average of 15.1. Cue the ominous music, because the market’s current P/E is similar to levels prior to the 2008 crash and the dot-com bust in 2000. A reversion to the mean would vaporize trillions in stock-market wealth.
But these worries overlook a key factor, says Sam Stovall, chief investment strategist for CFRA: inflation, which is currently 1.7%. Stocks “are expensive on an absolute basis, no matter which way you look,” Stovall says in the video above. “But that’s only one half of the equation. The other half is inflation. And if inflation is at 1.7%, we can afford a much higher PE ratio.” (Yahoo Finance will soon publish a podcast with a longer discussion on the likely direction of the stock market.)
Ordinary people may not think about it much, but we’re in an unusual low-inflation period with the prices of many products falling over time. That helps keep interest rates low, which boosts corporate profits and buoys stocks. Low inflation also requires less discounting of future corporate earnings, another factor that supports stock valuations.
If a high P/E signals a correction, then a low P/E ought to signal a surge in undervalued stock prices. But when the bull market ended in 1981, the P/E ratio for the S&P 500 was just 7. Inflation, however, was a scalding 14%, which left companies and consumers alike under deep stress that ultimately caused a recession, bringing stocks down.
Stovall measures P/E ratios relative to inflation using the “Rule of 20.” Here’s the formula: Subtract the inflation rate from 20, then multiply that number by the latest 12-month EPS figure for the S&P 500. The result is a “fair value” estimate of where the S&P 500 index should be. Since there’s a lag of several months in the actual EPS numbers, analysts use consensus estimates for current or future periods to determine if the S&P 500 is over- or undervalued in real time.
Stovall says the Rule of 20 shows the S&P 500 to be overvalued by 5%-7% right now. But estimates for 2018 suggest it will actually be undervalued by 5%-10% next year. That suggests a pullback could be coming — followed by a buying opportunity. That outlook depends, of course, on whether analysts predicting future earnings are correct — and whether anything unforeseen rattles markets.
The broader takeaway, in this view, is that the bull market now in its ninth year remains on solid footing, with no obvious reason for it to end. Stocks can always fluctuate in the short term, and nobody should play the market if they need the principle during a three- or four-year timeframe. If anything, there might be less to worry about than anxious investors believe.
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Rick Newman is the author of four books, including Rebounders: How Winners Pivot from Setback to Success. Follow him on Twitter: @rickjnewman