Are U.S. stocks overvalued?

Q: It is my understanding that the P/E ratio of the S&P 500 is hovering around 28. In the last 135 years, it had only been higher 4% of the time; once in 1929 and once just before the tech crash of 2000/2001. Do you think the future of U.S. stocks is a little obvious?

—Rod

A: There are many different ways to value stocks, ranging from the discounted cash flow (DCF) method to the price to earnings (P/E) ratio. The P/E ratio is probably the most common metric used by investors today.

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The two primary types of P/E ratios are trailing 12-month price to earnings and forward 12-month price to earnings. Trailing P/E ratios are calculated by dividing the price of a stock by the actual reported earnings of a company for the past 12 months. This is the ratio you are referring to, Rod. Forward 12-month price to earnings are based on an estimate of earnings for the coming 12 months.

Estimated earnings are not as reliable as actual earnings. But actual financial results of a company or a stock market over the past 12 months may not necessarily be a predictor of potential earnings for the coming year. Since stock prices are based on expectations for the future, one could argue that forward P/E ratios are more important.

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If a stock price is high and earnings are low, it will have a high P/E ratio and therefore may be overvalued. Think technology stocks in the dot-com bubble with no earnings. If a stock has a low P/E, the stock price may represent a good value. Value investors like Warren Buffet look for undervalued stocks.

Right now, the trailing 12-month P/E ratio for the S&P 500 is 24.68. Historically, this ratio has averaged 15.64 since 1871, so we are definitely above average, Rod and in the “red zone” so to speak.

That said, the forward 12-month ratio is currently 18.27 according to Birinyi Associates and the Wall Street Journal. This suggests that despite U.S. stocks sitting at all-time highs and trailing P/E’s in the red zone, stock prices remain reasonable at least based on estimated earnings for the coming year and the resulting S&P 500 forward P/E ratio.

Right now, U.S. stock investors are very optimistic about President Trump’s plans to stimulate economic growth with tax reductions, infrastructure spending and red-tape reduction. I suppose the question, Rod, is whether people are overly optimistic and this is resulting in overstated economic and stock earnings estimates.

Economic indicators are good, at least for now. U.S. unemployment is below 5% and approaching what economists would consider “full employment.” where unemployment is due primarily to an expected level of voluntary or temporary transitional employment. In other words, the U.S. labour market is firing on all cylinders.

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Stock markets look great. S&P profits are expected to hit all-time highs in 2017. Yesterday marked the longest stretch in more than 20 years that the S&P 500 has gone without a 1% drop – 104 consecutive trading days. The VIX, which is an index that gauges stock market volatility, is down 30% since Trump was elected.

There are a lot of reasons U.S. stocks are moving higher. But there’s also no doubt the odds of a correction increase with each passing day. Stocks can’t go up forever. But this rally may still have legs.

This reinforces the benefits of a globally diversified portfolio, Rod. In 2016, the S&P 500 rose 9.5%. But the TSX was up 17.5%. And the Shanghai Stock Exchange was down 12.3%. In any given year, different stock markets or different asset classes will zig while others zag.

If U.S. stocks continue to rise, investors should be trimming their U.S. stock exposure and buying whatever has gone down in their portfolio. Those who haven’t rebalanced in recent years may be unintentionally overweight U.S. stocks.

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Should you move out of U.S. stocks completely? I would say the answer is no. It’s hard to outsmart stock markets. And unless your time horizon is short to medium term, your risk of being out of the markets may be as great if not greater than your risk of being in the markets.

That said, risk tolerance is a fundamental part of investing. And if you are concerned about U.S. stocks or stock market exposure generally in your portfolio, Rod, it may be wise to reduce – but not eliminate – your allocations.

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Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.

About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

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