S&P 500 Peaks: Reviewing the Price vs. Value Debate for Investors
The S&P 500 closed at another all-time high (ATH) last Friday, February 2. It’s up about 4% for the year.
Is it time to sell?
We asked the same question last week. I suggested the answer is, “No” and gave four reasons:
Stocks are long-term investments. Click here to read more on that topic.
Value and price are different concepts.
Other markets are not at ATHs. Some groups of stocks like small caps, emerging markets, are still 10-30% their 3-year peaks.
It creates more opportunities for emotional decisions we would prefer to avoid.
Price vs. Value
Let’s look at the second reason this week - price vs. value.
Price is the easy part to quantify. The S&P 500 closed the week at the record price of 4,958.61. It has never been higher. And price alone, I would argue, is largely irrelevant.
An asset bought with a hefty price tag can both deliver or destroy a ton of value.
Side note: did you know the Dow Jones Industrial Average (DJIA) weights the 30 stock components by price? Meaning companies with a higher share price make up a larger portion of the index? Seems crazy, right? UnitedHealth (UNH), for example, trades for $510 per share, while companies like Apple (AAPL) and Coca-Cola (KO) trade at $185 and $60 per share, respectively. That means UNH has 8x the influence of KO and 2.5x the influence of AAPL on the DJIA’s performance, despite AAPL’s market cap being 6x bigger and KO’s being a little more than half that of UNH! This is just one reason most market watchers prefer to use indexes like the S&P 500 that use market capitalization to weight the constituents as their stock market proxies.
Trying to determine value is much more interesting. It is also much harder and much more subjective. With that said, I will use a few different ways of measuring the perceived value of U.S. stocks at these all-time high price levels.
All of these measures have one thing in common - price is part of the equation.
Price relative to historical results.
Price relative to expected results.
Price relative to alternatives.
Price relative to history
This one is pretty easy to measure. Divide price by some other measure, and compare the result to history. We will use the price (or level) of the index divided by all the profits generated by the companies within the S&P 500. You might hear people refer to the price-to-earnings, or P/E ratio. This is what they are referring to. Price divided by profits or earnings. This is one way to measure the relative value or “cheapness” of stocks. For example, assume you can buy $1 in earnings for either $10 or $25. Which would you prefer? All else being equal, paying less is generally viewed as a better starting point for investors.
S&P 500 P/E ratios are relatively high compared to the last 25 years.
At the end of last month, a buyer of the S&P 500 would have paid about 24x the profits generated by those companies from the previous 12 months. The chart below (click to enlarge) plots the P/E ratio of the S&P 500 going back to late 1999. Relative to the last 25 years, the P/E ratio has only been higher than it is now about 10% of the time, suggesting a poor starting point for S&P 500 index investors.
Another side note: the brown dotted lines represent +/- 1 standard deviation and the brown dashed lines represent +/- 2 standard deviations from the 25-year average, which is the black dashed line. This can help visualize extreme events that rarely occur.
Historically, returns from period with high P/E ratios have not been as strong as other periods.
Historical performance tends to agree. We looked at all other periods with similar P/E ratios since 1950, using 21x and 28x as our low and high cutoffs. The chart below plots the 1-year returns and the 10-year returns from these starting points.
Short-term results have been all over the place. But the median 1-year return of 6% is considerably lower than the median of ALL 1-year returns since 1950, which is 10.3%. This would suggest we may want to consider tempering our near-term expectations.
Long-term results have generally been better, with positive 10-year returns 90% of the time. Again, the median return from starting points with high P/E ratios (like today) is not as strong as the returns from all periods - 6.1% vs. 7.9%. Investors who use long-term capital market assumptions won’t be too surprised by these figures, as most long-term forecasts are calling for similar returns from U.S. stocks over the next decade.
Keep in mind, none of these results include dividends.
Price relative to expected results
Price relative to investors expectations is higher than the 25-year average.
This measure is nearly identical to the previous example. But instead of using historical results, this ratio uses forecasted earnings in the denominator.
With the S&P ending January at 4,900 and a forward P/E ratio of 20.4x, this would imply investors expect companies within the S&P 500 Index to generate about $240 per share in profits over the next year.
Since the late 1990s, forward price-to-earnings ratios have been lower about 80% of the time. Again, all else being equal, we typically anticipate better future returns when expectations are low. In the chart below, look at the low point, which happened in the depths of the global financial crisis in late 2008. The S&P 500 annualized return for the last 15 years, from that starting point, has been almost 15% per year. Put another way, $100,000 invested in a S&P 500 index fund in early 2009 would now be worth over $800,000!
Price relative to alternatives
I can think of a couple ways to measure this:
Compare the S&P 500 to other groups of stocks, like foreign developed market stocks, emerging markets, U.S. small cap stocks, etc.
Compare the current equity risk premium (ERP) to the historical ERP
We will cover the first bullet in a week or two. For today, let’s take a quick look at the equity risk premium.
We wrote about the ERP last summer and last spring, too. Click the links to read.
As a quick refresher, the equity risk premium is the “extra” return investors expect to earn above a risk-free rate for accepting equity risk. One way to measure this is by comparing the earnings yield on stocks, which is just the inverse of the price-to-earnings ratio, to the yield of a risk-free alternative like the U.S. Treasury security. While no investment is truly risk-free, U.S. Treasuries are widely used to represent this part of the equation.
This chart is a little busy, but worth a look.
Mixed expectations for the equity premium using bottom up processes.
Stock market investors would prefer to buy when equity risk premiums are high. If you look at the far right hand side of the chart, you will notice they recently turned negative.
For reference, I plotted the 10-year returns for the S&P 500 (again, price only), from each of these starting points. The 1990s bucked the trend, with good returns from low ERP starting points. Otherwise, long-term investors have generally earned better returns with starting equity risk premiums were higher.
Another approach published by NYU professor Aswath Damodaran infers an equity risk premium from current price levels and other variables. He generously publishes his work for the public, and the chart below shows the historical ERP using his bottom-up processes.
By these ERP measures, equities are still expected to deliver better returns than risk-free bond alternatives.
Summary
Value is subjective and it can be measured in different ways. Professional investors may attempt to estimate all the future cash flows generated by a business, or a group of businesses like those in the S&P 500, and assign a value in today’s dollars to estimate expected returns on their investment. Other investors will use metrics like the P/E ratios I included above to estimate value.
It seems difficult to argue that today’s starting point offers investors a “cheap” entry point into the S&P 500, regardless of your preferred approach. And yet, I think patient investors can still do just fine if their horizon is a decade or longer. Rather than avoiding stocks altogether, investors can adjust expectations or look for opportunities to rebalance in other markets where expected value might be more attractive.
As always, we would encourage investors to think of stocks as a means to accomplish long-term goals and keep a long-term perspective.
Data source is Morningstar Direct and St. Louis Federal Reserve (FRED).
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