Tyler B. from Baton Rouge, LA asks: Mitch, I saw an article the other day stating that P/E ratios are way above average and that something has to give. I’m a long-time investor, and I recently inherited some money, but I’m considering just keeping that money in cash because buying now would mean investing in overpriced stocks. What do you think?
Mitch’s Response: Articles about P/E ratios have been appearing more lately, which I think is largely in response to comments being made by Federal Reserve governors about potential frothiness in the market. The Federal Reserve Chairwoman, Janet Yellen, has been a part of this valuation narrative, making waves some months ago when she noted that the committee was taking notice of high equity prices “relative to historical standards.”
These comments are not without merit. As of the end of Q2, the forward P/E on the S&P 500 was 17.5x, which is materially higher than the 25-year average of 16.0x and also notably higher than the 15.4x average we’ve seen since 2000. To note, forward P/Es are calculated based on expected earnings for the S&P 500 relative to current prices, which while imperfect are more useful than looking backward.
Bottom line: stocks aren’t cheap. But, I wouldn’t call them overpriced, either. S&P 500 earnings growth hit 14% in Q1, and Zacks Investment Management expects full year growth to approach 10%. As long as corporations are hauling in earnings and revenues at that rate, I could envision valuations moving even higher.
Remember, too, that the last time we saw forward P/E ratios at current levels was early in 1998. That was a volatile year, but the S&P 500 still finished +28.34% higher and added another +20.89% in 1999. That eventually saw forward P/Es peak at close to 25x, when the bubble burst. We are not really close to those levels yet.
Another thing I’d like to point out is that the Feds speak on elevated P/Es has not been a reliable indicator in the past. Do you remember Alan Greenspan’s declaration of “irrational exuberance” back in the 1990’s? It is often viewed as a prescient forecast of the bubble bursting, but there’s one huge problem with it: he made that statement in 1996. Stocks more than doubled from the time he made that statement to when the bubble burst! In other words, it hasn’t been a wise move in the past to take Fed officials at their word, and I don’t necessarily think it’s a wise move now.
Does that mean you should invest all of your cash now? Not necessarily. It really depends on your long-term objectives for that money and how much of it you may need in the near term. If you want ideas for how Zacks Investment Management would put that money to work, just reach out to one of our Investment Advisor Representatives at 1-888-600-2783 and we will put together a proposal for you based on your goals.
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