But if you were able to have a socially distanced talk around the water cooler today, you and your debating partner would both be left scratching their heads.
Over the last week, the S&P 500’s forward price-to-earnings ratio, one of the main figures that investors use to measure the expensiveness of the market, has climbed to levels not seen since April 2002, when the technology bubble was in mid-burst. At the time of writing this column, the market had a forward P/E of 22 times, according to S&P Capital IQ, despite the fact that the index is still down 16% from Feb. 19, 2020, when it reached its all-time price high. According to Factset, its P/E is also well above its historical five-year, 10-year, 15-year and 20-year averages, though it’s still below its March 2000 peak of 24.2.
If you look at this metric, you’d think that the market is expensive. While the S&P 500 has climbed by 27% since Mar. 23, when stocks bottomed (or at least bottomed for now), it’s curious as to why its forward P/E ratio is hovering near record-breaking levels.
Pay attention to P/E
Investors should have an understanding of the P/E ratio, as it’s often a good (though imperfect) starting point for people who want to determine a company or market’s priciness. The ratio, which is calculated by dividing a company’s share price by its predicted earnings per share, indicates what investors are willing to pay for every dollar of future earnings. If the S&P 500 is trading at 22 times earnings, then people are willing to pay $22 for $1 of earnings. (In March, people were willing to pay $14 for every $1 of earnings—so, much less than they’re paying now.)
You can use a variety of P/E metrics, but forward P/E is the price people are willing to pay for future earnings as opposed to regular PE, which is the price the company is trading at right now. Investors tend to prefer using forward P/E, though the current PE is high, too, right now at about 23 times earnings.
There’s no specific number that indicates expensiveness, but, typically, stocks with P/E ratios of below 15 are considered cheap, while stocks above about 18 are thought of as expensive. Depending on your view of the market, expensive isn’t necessarily bad. Amazon’s forward P/E ratio has constantly been in the 70s and 80s over the last year—it’s at 101 times earnings today—in part because people are happy to pay more for earnings if they think the stock price is going to continue climbing. (Amazon’s shares are up by 25% since January.)
Many people like owning companies with lower P/E ratios because it could mean these companies have room to grow—usually, PE ratios rise along with stock prices—but it also protects on the downside, as cheaper businesses tend to fall less than more expensive ones during a market crash. Still, you don’t want to buy the cheapest companies. A P/E that’s much lower than the market or a company’s peers could be a sign that that business is in trouble.
Falling earnings, higher P/E
Clearly, earnings are an important part of this equation. So, what does it mean when, in a time like this, analysts are forced to cut their Q2 earnings estimates for S&P 500 companies by a whopping 28.4%? It means that, all of the sudden, people are paying a lot more for a company’s future earnings. You would think that if earnings were expected to fall by nearly 30%, stocks would also fall by an ungodly amount, and then the market wouldn’t look so expensive. But, as I’ve written before, investors remain optimistic that the pandemic, and its economic effects, will be short-lived.