S&P 500 P/E Ratio at Highest Level Since Early 2010
I am happy to present this week’s market commentary from FormulaFolio Investments. The goal is to give our clients and friends a simple way to see everything they need to know about the financial markets on a weekly basis, in 5 minutes or less. After all, finances should be simple, not complicated.
Equities: Broad equity markets finished mostly positive lead by international stocks. Higher oil prices and stronger than expected earnings reports from large retailers such as Kohl’s and Nordstrom helped push equities higher. S&P 500 sectors finished the week mixed with no discernable difference between cyclical and defensive sectors.
So far in 2016 telecommunications, utilities, and energy are the strongest performers while financials is the only sector with negative performance year-to-date.
Commodities: Commodities had a strong week as oil gained 6.44%. However, oil is still almost 14% lower than the high year-to-date levels seen in the beginning of June. Gold traded flat but remains considerably positive for the year.
Bonds: The 10-year treasury yield decreased slightly from 1.59% to 1.51%, leading to positive performance in treasury and aggregate bonds.
High yield bonds were positive as credit spreads continued their broad decline since mid-February and the markets continue to gain confidence in riskier assets.
Most indices remain positive (modestly) for 2016, with high yield bonds leading the way.
Lesson to be learned: Warren Buffett once said “the stock market is a device for transferring money from the impatient to the patient.” Impatient investors allow emotions to guide their decisions, often leading to self-destructive portfolio behavior. This is why is is important to remain patient. Maintaining a smart and disciplined investment strategy will improve your chances of long term portfolio success.
FormulaFolios has two simple indicators we share that help you see how the economy is doing (we call this the Recession Probability Index, or RPI), as well as if the US Stock Market is strong (bull) or weak (bear). In future posts, I’ll write more about how these indicators are built and why we feel they are important.
In a nutshell, we want the RPI to be low on the scale of 1 to 100. For the US Equity Bull/Bear indicator, we want it to read least 67% bullish. When those two things occur, our research shows market performance is strongest and least volatile.
The Recession Probability Index (RPI) most recently decreased from 29.8 to 25.33, which signaled a slightly positive shift in the US Economy. The Bull/Bear indicator is currently 33.33% bullish, 33.33% neutral, and 33.33% bearish (averaging 50% bullish and 50% bearish). This means our models remain neutral regarding the stock market direction in the near term (think <18 months).
Weekly Comments & Charts
The S&P 500 was mostly flat during another week of low volume trading compared to the rest of 2016. Though prices have been trending up recently, trading volume (the number of shares traded during a specified period of time) has been in a slow decline since the beginning of the year as illustrated by the second chart below. This could be a warning of a potential reversal due to a lack of interest in the market. Price increases (or decreases) on weak volume is not necessarily a strong signal. We would like to see increasing volume accompanying increasing prices. This would signal that the momentum has officially shifted to a more positive outlook. The coming weeks should give some valuable insight about whether the S&P 500 will turn the old level of resistance into a level of support or if the markets pull back again and retreat into the sideways/downward trading pattern.
The trailing 12-month price-to-earnings (P/E) ratio for the S&P 500 currently stands at 19.5, the highest level since early 2010. What does this mean for equity markets moving forward?
The P/E ratio simply takes the closing price of the S&P 500 and divides it by the trailing 12-month earnings per share (EPS) of the index. In essence, the P/E ratio indicates the amount of money an investor is willing to invest in order to receive a dollar of earnings. Though there is no “set in stone” value for analyzing P/E ratios, higher P/E ratios can indicate an overvalues market while lower P/E ratios can indicate an undervalued market.
The current 19.5 P/E ratio is above the trailing 5-year (15.9), 10-year (15.9), and 15-year (17.6) ratios for the S&P 500. At the end of 2015, the trailing 12-month P/E ratio was 17.9. Since then, the price of the S&P 500 has increased by almost 7% while the trailing 12-month earnings-per-share has decreased by almost 2%. An increase in the S&P 500 price combined with a decrease in earnings has placed upward pressure on the P/E ratio.
Though the P/E ratio can fluctuate regularly and does not give much insight as to the timing in market movements, this is something to keep an eye on. Compared to the most recent 5, 10, and 15-year time periods, the S&P 500 seems to be slightly overvalued at the moment. To fall back to the average P/E ratios, we would need to see an increase in earnings or a decrease in prices. Many companies have beat earnings estimates for Q2 2016, but the overall earnings decline for the quarter still stands at -3.5% which illustrates that the earnings portion of this ratio will not necessarily provide much support in the near-term. If prices continue to increase without earnings support it could create an overvalued market, making it more difficult to continue the broad bull market that began in 2009.
While market trends and history are useful for study, there’s always more to investing than just the charts and trends. We need to be a little cautious about increasing global uncertainties and the election that is right around the corner.
Most importantly, as investors we need to stay committed to our long term financial goals. All the short term news and market movements can be the most debilitating of all when it comes to making sound investment decisions; especially if we allow them to influence knee-jerk decisions.
More to come soon. Stay tuned.
Source: Phil Calandara