Whenever there’s talk about what drives the stock market, it usually comes back to two main factors: earnings and what investors are willing to pay for those earnings.
A common way to quantify this relationship is to look at something called a price-to-earnings ratio.
For a stock index like the S&P 500, this is found by taking the current price of the index divided by the earnings per share of the overall index. The higher the P/E ratio, the more investors are willing to pay for every dollar of earnings generated by the companies in the index. The lower the P/E ratio, the less they are willing to pay.
Our indicator above adds some bells and whistles to this concept to produce a measure that tells us when the stock market looks over/undervalued based on the P/E ratio.
Specifically, it uses the 5-year average of earnings to calculate the ratio to smooth out earnings volatility. It also makes an adjustment for the upward trend of the measure over time by applying a linear regression line with standard deviation brackets to the metric.
The way to interpret this indicator is that when the P/E ratio (red line) is above the upper standard deviation line, the stock market is considered overvalued relative to its 5-year average earnings. Historically, the S&P 500 has returned essentially 0% per annum when this is the case.
By contrast, when the indicator is below the lower standard deviation line, the stock market is undervalued, and the S&P 500 has returned roughly 15% per annum in that scenario.
What’s the indicator saying today?
After the most recent second-quarter update, the indicator has fallen between the standard deviation brackets. This is a historically neutral zone for stock returns, with the S&P 500 returning an average of 5.33% per annum going back to before the 1930s.
Now, valuation indicators like this one don’t make for great timing indicators. However, they do help set long-term return expectations.
For example, in the fourth quarter of 2020, this indicator first popped above the upper standard deviation bracket, signaling that the market was getting overvalued.
Sure enough, fast forward to today, and the S&P 500 has erased a huge chunk of the gains made since then.
Stocks got way ahead of themselves relative to what the underlying companies were generating in earnings, and now that monetary policy is no longer accommodative, investors aren’t willing to pay as much for those earnings.
The question now, however, is whether stocks will continue to get cheaper.
Although the P/E ratio calculated by this indicator is below the upper standard deviation bracket, it’s still above the midpoint of the linear regression line. It could still fall quite a bit further before it reaches the lower zone, indicative of an undervalued market.
The key will be to look for when the measure bottoms out and starts moving upwards again. This will be the point at which investors have likely decided that the market is a good value again.
This is intended for informational purposes only and should not be used as the primary basis for an investment decision. Consult an advisor for your personal situation.
Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.
Past performance does not guarantee future results.