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17X – Not a Fitness Program, but It's Still PE

I’m a huge fan of P90X fitness programs, but 17X is not about fitness.  It’s about the U.S. stock market.

The stock market is a forward-looking barometer and reflects the future expectations of the economy.

One of the oldest and commonly used metrics to value individual stocks and the stock market is the price-to-earnings ratio (P/E ratio).  The P/E ratio is defined and calculated as market price per share divided by annual earnings per share.

In general, a low P/E may be viewed as being undervalued.  In contrast, a high P/E may be viewed as over-valued. 

Our focus is the U.S. stock market and its aggregate P/E.

Since the U.S. stock market tanked during the Great Recession, we’ve seen a consistent and steady rise in the market, even with the wild, but mild corrections along the way.

There are lots of people suffering from disbelief that the bull market has run so far.  So, they keep claiming we’re in bubble territory.  This may seem reasonable given all the commentary about uncertainty in the media and recent correction.

If you know me, you know I’m not going to speculate about what’s going to happen going forward because I have no idea.  The markets could either go up from here or stumble and fall – or do nothing and remain flat.

Still, let’s look at the facts.

Historically, the P/E ratio for the S&P 500 has been somewhere between 12-22, with a long-run average of about 17.  The P/E fluctuates depending on economic conditions.

At the height of the dot-com and housing bubbles, the aggregate P/E of the S&P 500 was off the charts.  Today, however, the PE for the S&P is around its historic average

S&P 500 PE Ratio

 

The next chart plots the S&P 500 (black line) against actual earnings multiplied by 17 (solid red line).  The chart also includes the consensus earnings forecasts for 2015 and 2016 (the red dashed line).

 S&P 500 Earnings multiplied by 17x historical average.

 

This is not a forecast or prediction.  It’s simply a calculation to illustrate a path that the S&P 500 could reasonably take given the current outlook for economic and earnings growth coupled with continued expected low inflation.

Yes, it is true that what goes up, will come down.  But, sometimes it stays up for quite a long time (e.g., 1993-2000).  The gap between the black line and red line from 1993 to 2000 was a bubble.  It burst in 2000 and brought stock prices back into line with underlying fundamentals.

Earnings and stock prices began moving together again in 2002.  And for several years following the financial crisis of 2008, earnings actually exceeded stock prices.

The current data suggests that the U.S. is not experiencing a stock market bubble or heading toward one in the near term.  It’s suggesting that the U.S. stock market has finally normalized.


 

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Disclaimer: These opinions are for informational and educational purposes only.  Past performance is not indicative of future results.  Investments involve risk and unless otherwise stated, are not guaranteed.  We do not recommend that anyone act upon any investment information without first consulting with a qualified investment advisor.

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