A Price-Earnings ratio (P/E) is a shortcut. It has two simple inputs: 1) Price and 2) Earnings.
Can valuing a market, or a stock be that simple? No. Markets are complex. Read on.
While the price and underlying earnings are important, understanding the context is paramount. Movement in interest rates, understanding of economic cycles and earnings, prevailing investor sentiment, and sector composition are important inputs into building the context.
However, interest rates are the lynchpin. Let’s start there….
Chart 1: S&P P/E and Interest Rates
Source – Yardeni.com
Interest Rates: The P/E ratio is inversely proportional to interest rates. The present value of future cash flows changes, as interest rates change. For this discussion, let’s use the 10-year treasury yield (red line) in chart 1 as the interest rate. Therefore, when interest rates are high - the P/E ratio is low - and vice versa. In the 1970s when inflation and interest rates were bordering on double digits, the P/E ratio was close to 10. Despite the low P/E, markets were flat for a decade in the '70s, because rates kept rising. During 2015-20, inflation was non-existent and interest rates globally were low. In Europe, interest rates were negative. It should come as no surprise, the P/E ratio was close to 20. Despite the high P/E, markets did well because rates fell. Therefore, it is important to understand the P/E ratio in the context of 1) where interest rates are in the present relative to history, and 2) where they may be going.
Chart 2 - S&P and Earnings Growth
Source – Ned Davis Research
Economic Cycles and Change in Earnings: As earnings growth accelerates, the P/E ratio expands. The acceleration gives investors a higher degree of certainty about the future. Therefore, investors pay up, which is reflected in a higher P/E. Typically, earnings rise for several years after a recession. Therefore, the P/E expands (grows) at the depth of a recession in anticipation of a new economic cycle. The reverse is also true. As earning growth decelerates after a long economic expansion, the P/E ratio contracts as the likelihood of bad economic outcomes rise.
Chart 3 – S&P vs S&P Earnings
Source – Canaccord Genuity, Ned Davis Research
Investor Sentiment: There are three unique periods in recent history when investor sentiment played a large role in valuation. 1995-00 was a period of euphoria. Investors believed the internet was transformational and therefore, no price was high enough. This ended with the Dot Com crash. On the contrary, the 2001-04 period was an outlier with low valuation despite good earnings growth for two reasons: 1) 9/11 created societal uncertainty, and 2) major corporations (Enron, WorldCom, and Tyco) were embroiled in accounting scandals and corporate dishonesty. Investor belief in the system eroded. Similarly, 2009-2013 was an aberration for P/E ratios. Despite solid earnings growth and historically low-interest rates, the P/E ratio was historically low. The global economy was recovering from the Great Financial Crisis. Investors lacked confidence in future growth, which was reflected in a low P/E.
Chart 4 – Historical S&P Sector Composition
Source – DWS Investment Management
The Composition of the market: Sector weights ebb and flow and impact the overall P/E. Like in 2000, technology was the largest component of the market in 2021 (chart 4). Cyclical sectors such as Energy, Industrials, and Materials were at historical lows. In 2006, it was the opposite. Energy, Industrials, Materials, and Financials had a significantly larger weighting in the S&P.
Cyclical sectors have a lower P/E ratio. Simply, they are cyclical, and investors pay less for future earnings due to higher uncertainty. Therefore, comparing the S&P P/E across history without normalizing sector weights is a mistake. It's comparing apples to oranges.
Chart 5 – Change in S&P Forward P/E
Source – Alpine Macro
Changes In P/E: In 2022, as rates catapulted from 1% to 4.5%, the S&P P/E ratio had one of the most significant declines in modern history (chart 5). The only historical period in the past 40 years when the drop was more severe was the crash of 1987. The shaded bars in chart 4 are recessions. Outside major disruptive events, after a large fall, the P/E rises. This historical context challenges the current consensus thinking that P/E will drop further as earnings continue to decrease. Therefore, if inflation collapses in 2023, will P/E rise rapidly?
The P/E ratio is a simple shortcut. However, markets are complex. When it comes to P/E, don’t keep it simple.
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