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With extraordinarily high PE ratios, stocks appear overpriced Thumbnail

With extraordinarily high PE ratios, stocks appear overpriced

The US stock market indices gained over 3% last week, with the S&P 500 climbing to its highest level since early March, and up 32% from a recent low on March 23. Nearly all of the week’s positive momentum came on Monday, when the S&P 500 surged more than 3% for its best day since early April. Most of the gain came early in the day following comments from U.S. Federal Reserve Chairman Jerome Powell and a positive announcement from a pharmaceutical company that’s seeking to develop a coronavirus vaccine.

The next several paragraphs going into greater depth and start getting into the weeds with some data, so if that’s not your thing, you may just choose to quit here.  If not, please forge ahead, because we did some additional research last week, following a news report that the PE ratios were getting very high, so we wanted to dig deeper.

According to data provided by JP Morgan Investment Management, the S&P 500 earned $161 in 2019.  The forward earnings (expected for the next 12 months) on February 19, 2020 at the market peak was $178, and with the S&P 500 valued at 3,386, it had a PE ratio of 19.0.  On May 14, 2020, the S&P 500 was valued at 2,853, and with a consensus forward earnings estimate of about $140 per share, it had a forward PE ratio of 20.3.   To put this into perspective, the 25-year average PE ratio is 16.3.  Thus, a PE ratio of 20.3 may be considered “expensive”, implying that the stock market may be overpriced.

According to JP Morgan, they believe that the consensus earnings estimate of $140 is too high, as they believe the earnings should be around $125 for the S&P 500.  Using the May 22 value of 2,955 for the S&P 500 and JP Morgan’s estimated forward earnings, that would put the market at a forward PE of 23.6, even more significantly overpriced.

So, one should begin by asking the question of what will earnings be in the future?  According to John Hancock Investment Management, 75% of the 500 companies abandoned their previous earnings estimates.  I also heard two other reports – JP Morgan recently said that 47% of the S&P 500 companies refused to provide their earnings estimates, and another source said 147 companies have refused to provide their earnings estimates.  Note that the difference may be how their percentages were measured, but the conclusion remains the same – forward earnings are uncertain.

So let’s also look ahead.   The consensus estimate for earnings in 2021 is $162.  Really?   The consensus believes that the earnings in 2021 will surpass that of 2019? Given the significant impact we have experienced to the economy from the COVID-19 pandemic, the question is not the depth of the recession, but the length of the recession.  The summer often represents the height of the “spending season”, as consumers generally travel and spend more.  Many states continue to restrict many businesses from opening, and even if they were open, plenty of consumers continue to remain worried about being out in public.  Thus, we can expect that certain areas of the economy will continue to lag prior years’ earnings, such as leisure, airlines, hotels, restaurants, and entertainment.   So, is it fair to believe that 2021 will exceed that of 2019?  That seems unlikely.

In conclusion, our opinion is that it seems like the markets are forging ahead with little regard to the fundamentals.  For those of you who know me well enough, that concerns me.  While a historically low interest rate environment can support higher PE ratios for the market, these PE rations are extraordinarily high – maybe too high.  In summary, we don’t believe the S&P 500 deserves to be almost 12.7% off its all time high, when earnings estimates are 21% - 30% below where they were at the market peak.  Thus, if the markets continue to rally (like they are beginning to do today), I can see us taking some stocks off the table and capturing those gains.  Better safe than sorry, right?

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