The S&P 500 (SPY) is off to a good start in 2017. Yet despite all the gains, there still seems to be so many unhappy investors because they can't understand why the market keeps rising. They appear to believe the S&P has become just too expensive. Others seem to think the S&P 500 is just frankly up "too much."
What exactly that means even has me confused at times: up "too much" from when? The lows of 2009, the highs of 2007, or since 1929? Something going up "too much" isn't a reason for it to come down. In fact, maybe I have been spoiled over the years, but to me, a market that is up about 9 percent as the end of the second quarter approaches seems alright but not spectacular. But when we consider that the S&P 500 had mostly traded sideways for nearly two full years from the start of 2015 through the presidential election in November 2016, it doesn't seem like that much.
In fact, since the election, the S&P 500 is up 14 percent.
Perception vs. Reality
The first part is about the perception when one looks at a chart like the one below. The S&P 500 looks like it is up an awful lot, so therefore, it must be overvalued, right?
What if I showed you another chart giving you a different perspective?
Seen in this light, it doesn't like we are up so much anymore, does it? Not when compared to past decades. The chart above is a logarithmic graph. It essentially shows us what the S&P 500 looks like in percentage terms. For example, a 5 percent move in the S&P 500 when the index was at 500 was 25 points. At 2000, it is 100 points; same 5 percent but numeric values which skew the numeric chart.
What makes the S&P 500 expensive today? The fact that it is up 9 percent year to date? No. How about we compare it to historical P/E's and just see how expensive it is.
According to the S&P Dow Jones Indices, the S&P had earnings of $94.55 per share in 2016. That number is expected to jump to $118.39 per share in 2017, and to $133.76 in 2018. At current levels, the S&P 500 is trading a 2018 forward EPS of about 18.2. Sound expensive? I guess, but compared to what?
The S&P Dow Jones provides historical P/E data going back to 1988. Calculating the average P/E since 1988 in the S&P 500 brings us to 24.28 if we include every year. If we strip out the fourth quarter of 2008 through the third quarter of 2009 due to the financial crisis, that P/E ratio falls to 21.65 with a standard deviation of 6.3. Using this metric, the current S&P forward P/E ratio still falls well within the normal range over the past 30 or so years. For comparison, the S&P 500 had a P/E of 33.52 in the first quarter of 1999. Even on a trailing earnings basis, the S&P is currently trading around a 24 P/E, which is approaching overvalued, but still within the band of the historical norms.
Time will tell whether or not the markets are overvalued, but from looking at these measures, it is a stretch to say the market is.
In fact, what does 21 times 2018 estimates of $133.76 equal? 2,809. Think about that!
Michael Kramer is the Founder and Portfolio Manager of Mott Capital Management, LLC a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.