The U.S. stock market turned in a strong first month of 2013 as the S&P 500 gained 5.2%.
This coming after a 16% total return for the S&P 500 in 2012 has some wondering if the rally is close to exhaustion.
While we don’t expect double-digit gains to build throughout 2013, we don’t think the market is close to being overheated either. We’re not making a forecast but thought it might be helpful to see a couple charts that help explain value of the market. Of course, these charts and analysis portray a rational view and markets can become irrational from time to time. There’s no sense in trying to predict a return for the year or any short time frame. As Warren Buffett has said: “short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also grown-ups who behave in the market like children.” However, we can confidently forecast that you’ll want stock market exposure over long periods regardless of short-term results.
So on with the show.
Two charts from presentations I’ve watched recently demonstrate how market prices may have room to grow to catch up with the reported earnings of U.S. companies.
This view of S&P 500 inflection points is from J.P. Morgan. Look at the first peak, March 2000. A measure of market value is the price/earnings ratio of the market. What price are investors paying for each dollar of company earnings. At this euphoric time, the P/E ratio (based on forward earnings expectations) was over 25. It had become excessive and the market needed a cleansing to get back down to a P/E ratio closer to historic norms.
The recovery from the internet bubble peaked in October 2007. At that time, even though the price of the S&P 500 had surpassed the March 2000 price, the price/earnings ratio was 15.2, 40% below the 2000 P/E ratio. The market had not been bid up by speculative investors quite like in 2000. Of course, that didn’t stop a significant bear market due to the credit crisis and recession of 2008.
So where are we at today? The recovering S&P 500 has crossed a price of 1,500 again. But corporate earnings have also grown at a strong rate. This means the price is generally justified by the earnings. The forward price/earnings ratio at the end of 2012 was just 12.5, roughly half of the irrational exuberance peak of March 2000.
Add January’s price appreciation and the forward P/E ratio is about 13.3.
The combination of earnings and investor confidence in the trajectory of those earnings will be critical to determining how long this rally will continue.
Here’s another view – from economist Fritz Meyer – demonstrating how the market price has some catching up to do if history can be trusted as a guide.
The black line of the S&P 500 price over the past 25 years has generally kept an edge above the red line (S&P 500 earnings). It’s clear to see however, that the late 1990s S&P 500 value and the 2007 value grew disconnected from the reality of earnings.
Since 2010, though, good corporate earnings have not been reflected in stock prices that grow at the same pace. The S&P 500 black line has spent most of the time below the earnings line. Look at projected earnings going forward for 2013 and 2014 and you could rightfully judge that there is justification for stock prices to continue growing without getting too expensive.
Recovering investor confidence could have something to do with that. If cash flows shift back toward stocks and away from the bond market, gains may continue.
Of course, there are many potential shocks to the global economy which could erode emerging confidence and disrupt the growth in corporate earnings. But at this point, even significantly lower earnings would justify the current value of the S&P 500.
The S&P 500 is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor’s.
- How confident are you in the stock market?
- Have you changed the weight of stocks in your portfolio recently?
~ Gary Brooks, CFP® – Brooks, Hughes & Jones – Partners in Wealth Management – Tacoma, WA