Weighing Optimism and Caution – Interpreting the Nature of Stock Market Rallies though the PE Ratio

The stock markets including those in the US, recently broke record high prices, despite the presence of various negative economic factors. While there are investors who are content to buy stocks at these record prices, others remain skeptical about the current state of the market. Such cautious investors may delve into fundamentals, including the Price-to-Earnings (PE) ratio, to understand the nature of the market rally before making an investment decision.

The PE ratio is a key financial metric that helps investors assess a company’s valuation. Essentially, it indicates how much investors are willing to pay for each dollar of a company’s earnings. A high PE ratio suggests that the stock may be overvalued that it could be pulled back to its fair market value, while a low PE ratio suggests that the stock may be undervalued and that it has a potential for future growth. Although it is not the sole determinant of stock value, it serves as a useful tool in valuation. However, non-professional investors might often overlook it.

Understanding the value of stocks can be challenging, as it is often counterintuitive. Consider the stock prices of Target ($167.83) and Walmart ($60.83) at the time of writing. At first glance, it is apparent that Target’s stock price is higher than Walmart’s. However, for every dollar spent on these stocks, Walmart is actually more expensive than Target. This is because investors are paying nearly 70% more in terms of corporate profits for the former compared to the latter: Walmart’s PE ratio is 31.82, whereas Target’s is 18.75 . This means that they are paying $31.82 for one dollar of profit for Walmart, and $18.75 for Target, making the latter a more attractive investment option for those concerned about value, despite its higher stock price.

Beyond individual stocks, we can also examine the level of the PE ratio for the broader market. A Nobel laureate Robert Shiller developed a Cyclically Adjusted PE ratio (CAPE), also known as the PE10. This is an inflation-adjusted PE ratio, calculated over the previous ten years from a monthly reference point for the S&P500, an index of the 500 largest companies in the US. Shiller discovered a negative relationship between the PE10 and forward ten-year stock returns; the higher the PE ratio for the past ten years, the lower the stock returns for the next ten years, and the lower the PE ratio for the past 10 years, the higher the stock returns for the next ten years.

One can see the most recent ten-year stock returns predicted by the PE10 from its figure in January 2014, which was 25, indicated by the left green line in the scatter plot above. According to Schiller’s data, the expected annualized real stock return (inflation-adjusted) for the next 10 years ending in 2023 would have been around 3-4%, following the red trend line. However, the actual annualized and inflation-adjusted return during this period of 2014-2023 was 10%, exceeding the predictions based on historical PE10 data.

This finding suggests that, due to the excess return the stock market has yielded, there may be an increased risk of a major downturn. As of March 2024, the PE10 stands at 34.5, which is well above the historical average of 17. In recent decades, the PE10 has reached high levels, followed by market crashes and less severe downturns; it was 44 before the dot-com bubble burst in 1999 and was around 38 before the bear market of 2022.

Due to its predictive power, Shiller’s CAPE (PE10) shows the market is not as efficient as commonly believed. A dominant view academics hold about the market since the development of research in stock prices in the 1960s is that it reflects all publicly available information, and it is not possible to forecast future returns. However, while it is not feasible to predict day-to-day price movements or those in a month, one can have an educated prognosis about the long-term stock returns based on CAPE.

Furthermore, understanding that the market is not always efficient allows one to consider various economic data besides the PE ratio when determining the present state of the stock market. Recent mass layoffs in the technology sector, thousands of retail store closures, and consumer debt levels surpassing $1 trillion, among other factors, point to the economy’s fragile condition both at corporate and individual levels. Taking these into consideration, I maintain a cautious outlook on the stock performance over the medium to long term.

In contrast, the public at large might have an opposite view, believing that the market will continue to rise. This optimism for future stock returns is partly caused by the recency bias, whereby investors are heavily influenced by the recent performance of the market, and overlook historical data. This optimism continues until such belief is reversed, which, in turn, leads to panic selling.

While the allure of making short-term gains from stocks is tempting, it is wise to expand the investment time horizon, which allows one to have a holistic view of the economy. Therefore, when stocks appear to be driven mostly by investor enthusiasm detached from market fundamentals, spreading risks into other asset classes, such as bonds and money markets, could result in a resilient portfolio over the long term.

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