How Will Valuation Levels Normalize?

April 19, 2017 | Nat Kellogg, CFA, President, Director of Manager Search

Active U.S. equity managers regularly point out that the stock market looks expensive, and as a result, they are having trouble finding good companies to buy. Our chart this week looks at the median P/E for the S&P 500 Index over the last decade compared to the current P/E (our E is based on trailing twelve months operating earnings). Not only does the broad index look expensive relative to history, but each of the sectors in the index also appears to be overpriced. But how overpriced? The green bars indicate the price correction needed to bring the index back in-line with the historic median P/E ratio. At current valuation levels it would take a full blown bear market (a price correction over 20%) before the market looks reasonably valued again.

However, there is another way for P/E multiples to normalize over time; an increase in earnings without a change in price. The orange bars show the earnings growth needed to bring the index back in-line with historic valuation ratios. While 27% earnings growth for the S&P may seem optimistic, investors should realize that after seven straight quarters of negative earnings growth from 4Q14 to 2Q16, overall index level earnings are growing again. Year-over-year earnings growth hit 21% in 4Q16 and analysts currently expect S&P 500 earnings to be up 22.6% in 2017.

Lastly, astute observers will notice our analysis excludes two S&P sectors. Real Estate is excluded for a lack of historical data, as it just became a stand-alone sector back in 2016. Energy is excluded because energy sector earnings are currently so low the P/E multiple is essentially meaningless. But investors are expecting energy earnings to bounce back in 2017, and play a key role in driving overall S&P 500 index earnings growth.

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