Don’t forget about “Earnings” in the Price/Earnings Ratio

It’s ugly out there.

While the U.S. stock market may be closed in honor of Dr. King, overseas markets and the commodities markets are still trading – and dropping – like rocks. The price of crude oil dropped to a 13-year low this morning… which probably means more pain tomorrow when the U.S. markets open.

After the tumble stocks have taken this month, we’re already hearing a growing chorus of market pundits saying that the market is “cheap.” Well, it’s cheaper than it was a month ago, that’s for sure.

But anyone claiming the market is cheap isn’t telling the whole story.

The price/earnings (P/E) ratio is the most common measure of market value. When stock prices are high relative to their profits, stocks are expensive. When stock prices are low relative to their earnings, stocks are cheap.

Today, the S&P 500 trades at about 16 times the consensus estimate of 2016 earnings, which puts it more or less in “average” territory – neither cheap, nor expensive.

There’s just one problem here: estimates for earnings are dropping like a rock.

Last quarter, 84 companies in the S&P 500 lowered their earnings estimates for 2016. And forgetting about projections for a moment to look at real-life results, S&P 500 earnings dropped last quarter for the third quarter in a row.

Ouch.

Falling earnings mean that, even if stock prices don’t move a single point, the market gets more expensive when measured by the P/E ratio. It’s a moving target with a lot of noise mixed in, which is why some of the greatest value investors in history ditched the P/E in favor of the cyclically-adjusted price/earnings ratio (“CAPE”).

The CAPE, which was introduced by Benjamin Graham in the 1930s, takes a 10-year average of earnings rather than a single year. The idea is that this filters out some of the year-to-year noise and gives you a truer idea of how cheap a stock is, regardless of where we are in the economic cycle.

So, with that said… where are we?

In nosebleed territory, it seems.

The S&P 500 trades at a CAPE of 23.9, which is only slightly cheaper than it was before the 2008 meltdown. This implies annual returns over the next eight years of just 1.1%.

So, if you’re invested in this market, you had better not be buying and holding the S&P 500.

There are different ways to skin a cat, of course, and lots of strategies work well in bear markets. Deep value and momentum strategies can post respectable returns regardless of which direction the broad market is heading, and shorter-term trading strategies can be viable as well.

Given today’s valuations, however, any strategy that depends on the broad market posting outsized returns is almost guaranteed to lead to disappointment.

Charles Sizemore
Editor, Dent 401k Advisor

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Categories: Investing

About Author

Charles Sizemore is a research analyst with Dent Research. His primary research focuses on income, retirement strategies and fundamentals.