What the P-E Ratio Is Saying

P-E Ratio Graph

 

 

 

 

 

 

 

With the S&P 500 index of large US stocks having risen by close to 150% since its trough during the financial crisis, are US stocks now overvalued? One way to answer this question is by looking at the price-to-earnings ratio (or “P-E ratio”), which measures how high stock prices are relative to the profits that companies are generating. If the P-E ratio for the market as a whole is higher than its historical average, investors may be overvaluing stocks and the future returns from investing in the stock market may be below average.

The P-E ratio for the S&P 500 is currently about 19.5, above its historical average of around 15.5, suggesting that stocks are slightly overvalued. But one problem with using P-E ratios is that companies’ earnings can bounce around a lot, making historical comparisons difficult. In hindsight stocks were clearly overvalued in the late 1990’s, when euphoria about the prospects for technology companies pushed the P-E ratio for the S&P 500 above 30. But the market’s P-E ratio also surged in early 2009 as companies’ profits collapsed during the financial crisis, and that coincided with the start of the current bull market.

One way to get around this problem is to use the average of companies’ profits over a number of years. Robert Shiller, a professor at Yale University and recent recipient of the Nobel Prize in Economics, popularized a calculation that averages earnings over a 10-year period. According to his calculations, this 10-year P-E ratio is currently above 25, substantially higher than the long-term average of around 16.5. This metric has its critics as well: some argue that it puts too much weight on periods of abnormally low profits, such as the financial crisis. Proponents retort that historically it’s been one of the most accurate ways to predict future stock market returns.

So are US stocks currently overvalued? According to either of these measures of the P-E ratio, the answer is yes.

Different Countries, Different Sectors

Map

US and international stocks often perform differently, which is why the result of owning both is usually a better-diversified portfolio. There are many reasons for these performance disparities, such as different economic conditions, different laws and regulations, and different effects from currency movements. Yet there’s another key difference that’s often overlooked: US and international stock markets tend to be made up of very different types of companies.

Led by companies such as Apple, Google, Microsoft, technology is the biggest sector in the S&P 500 index of large US stocks. Since there are fewer large technology companies based in foreign countries, however, technology is one of the smaller sectors among international stocks. In the other direction, the financials and materials sectors are much better represented among international stocks than among US stocks.

For individual countries, the differences with the US can get even more extreme. About half of Russia’s stock market is comprised of energy companies, compared to less than 10% in the US. And many emerging markets, including Brazil, China, and Russia, have almost no companies in the health care sector.

As a result of these differing sector breakdowns, factors that help or hurt a specific sector can disproportionately affect the performance of stock markets in some countries. When deciding how to invest internationally, understanding the implications for the sector exposures of your portfolio is an important consideration.

Debunking January’s Predictive Power

January“As January goes, so goes the year” is an often-quoted stock market aphorism suggesting that how stocks do in the first month of the year can predict how the following 11 months turn out. Last year, for example, the S&P 500 index rose more than 7% in January on its way to gains of more than 30% for the entire year. But how often does that relationship hold true?

The Economist’s Stanley Pignal crunched the numbers to answer that question. He found that stocks do indeed tend to do better over the course of the entire year when they rise in January, which makes sense since the returns from January are part of the returns for the entire year. But when the January performance was excluded from the full-year numbers to see how stocks do only in the last 11 months of the year, there’s almost no relationship between the two numbers.

In other words, January doesn’t seem to have the claimed predictive power of lore. Perhaps that’s some comfort to investors who suffered from last month’s stock market declines.

Obama’s Retirement Reminder

State of the Union 2014
State of the Union 2014

In his State of the Union address last week, President Obama announced a new type of retirement account called “MyRA” to try to encourage Americans to save more money for retirement.

The new account is essentially a Roth IRA: workers put in earnings on which they’ve already paid income taxes and then don’t have to pay taxes on any investment gains as long as they wait until retirement to spend the money. The main differences are that the new account will include features to encourage small amounts of saving for people who can’t afford to make large contributions to a retirement account, and contributions are automatically invested in low-risk government bonds.

Investing only in low-risk government bonds isn’t ideal for most people saving for retirement.  Low-risk also means limited potential investment gains, and investors who aren’t planning to retire imminently can usually afford to take more risk to try to achieve higher returns.

Yet even for those who won’t use myRA accounts, the fact that the federal government feels the need to encourage people to save more for retirement should serve as an important reminder about the need to build up a nest egg. According to the Center for Retirement Research, half of American households are at risk of not being able to maintain their standard of living in retirement. Insufficient retirement savings are a problem for so many people that it’s become a national issue.

Different people have vastly different needs, so there’s no exact formula to determine how much money you need to live comfortably in retirement. There are many rules of thumb that people often use, such as “save at least 10% of your income for retirement”. Here’s another one: if you’re not sure if you’re saving enough and you can afford to save more, you probably should.