Aug 5, 2021 - Economy

The stock market has gotten cheaper over the past year

Data: FactSet; Chart: Axios Visuals
Data: FactSet; Chart: Axios Visuals

A widely followed valuation metric suggests stocks have been getting cheaper over the past year, even as prices have surged to new highs.

Why it matters: When stocks rise and company market caps balloon, it’s tempting to think that the shares must eventually fall in order to get to more reasonable levels.

  • This doesn’t have to be the case when earnings prospects are improving.

The big picture: Perhaps the most widely-used measures of value in the stock market is the price/earnings (P/E) ratio. Simply put, that's the market value of a company divided by its earnings.

  • When the P/E ratio is above some long-term average, the stock is thought to be expensive. If it’s below average, then it’s cheap.
  • For the denominator, it’s common to use “forward” earnings, or the earnings the company is projected to generate in the next 12 months.
  • The P/E ratio can be applied to broad market indexes like the S&P 500.

By the numbers: The S&P 500’s forward P/E touched a high of 23.6 on August 28, 2020, according to FactSet. That day, the S&P closed at 3,508. Since then, the forward P/E has trended lower, registering at 21.2 as of July 30.

  • During that period the S&P surged 25% to 4,395.

Between the lines: This dynamic has largely been driven by months of improving expectations for earnings.

  • And during the current earnings season, most companies have proven that analysts’ forecasts for earnings continue to be too conservative.

Flashback: These unusually conservative expectations for earnings can be tracked back to early 2020 when neither companies nor analysts understood where things were headed. They just knew things were bad.

  • “During the worst part of the pandemic, analysts were basically flying blind,” Liz Ann Sonders, chief investment strategist at Charles Schwab, tells Axios. “What they ended up doing in that environment was they erred on the side of just slashing estimates.”
  • Companies went on to report better-than-expected earnings quarter after quarter. But analysts were anchored in their conservative outlooks.
  • “In turn, the forward P/E over the last year has been sort of artificially high because analysts have had the estimates for the forward quarters somewhat artificially low,” Sonders explains.

Yes, but: Even at a forward P/E of 21.2, this multiple is above average. According to FactSet, the 10-year average multiple is closer to 16.2

But, but, but: Sonders cautions against putting too much weight into long-term historical averages as the macroeconomic environment has evolved greatly.

  • For one, she notes that historically low interest rates are supportive of higher valuations, a sentiment shared by the likes of billionaire Warren Buffett and even Fed Chair Jerome Powell.
  • Also, a growing share of the S&P consists of tech companies, which warrant relative high valuations thanks to their more favorable growth prospects.

The bottom line: An elevated P/E ratio alone is not a reason think stocks are doomed to fall.

  • “Sometimes high multiples are not ‘what you see is what you get,’” Anastasia Amoroso, chief investment strategist at iCapital Network, tells Axios.
  • “It is typical in a quickly recovering economy to see earnings get revised higher and beat consensus, leading to same or even lower multiples. When accounting for these higher earnings, the ‘true’ multiples may not be as expensive as they seem.”
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