A 53 Year Perspective – S&P 500 More Room to Run?
Over the past several weeks the equity market has paused in the multi-year rally with the S&P 500 within 4 points of its all-time high of 1775. Since March 9, 2009, the S&P 500 has averaged a 25.1% annualized return with a total return of 186%. There is growing concern over the valuation of the market. The S&P 500 has not seen a 10% correction in nearly 18 months. Has it gone too far too fast? Is the market now richly valued and due for a correction? One could make the argument that the Federal Reserve’s quantitative easing stimulus program may have artificially inflated the valuation of the market, making this rally one which may have been built with funny money rather than on strong fundamentals.
Looking at the market from the perspective of earnings, and seeking to quantify valuation, a traditional approach looks towards the price-to-earnings (PE) ratio, a simple measurement of what investors currently are willing to pay based on the collective earnings of the companies that make up the market. As of today the S&P 500 is trading at 1771, and the combined annual earnings of all of the companies in this index is $105.6/share. When we divide the price of the market, 1771, by the earnings of $105, we arrive at a current PE ratio of 16.7. Is this a fair price to pay? Since 1960, the average PE ratio has been 16.5 suggesting that on a historical basis this market is fairly priced. However, for readers of this column, you’ll know that a regression analysis is helpful to determine if valuations are extended, discounted or somewhere in between. The chart below spans the 53 year period 1960-2013 and illustrates the PE ratio of the S&P 500. The green vertical bars are quarterly ranges; the chart’s horizontal lines display the mean in red, one standard deviation in gray and two standard deviations shown via the upper and lower green lines. From this chart we can see that the mean has been increasing, and as of today, the market would appear undervalued at 16.7 times earnings. A reversion to the mean (red), which is 18.8 times earnings, would equate to the S&P 500 trading at 1986 – 215 points higher than where the index is trading currently or up 12%.
This article has been written for the general information of clients and friends of Bell State Bank & Trust. It is not intended, nor may it be relied upon, as legal, tax or investment advice with respect to any matter. This article also cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by the Internal Revenue Service or other taxing authority.
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