The S&P 500 P/E Ratio: An Indicator of Overvaluation or Future Growth?

The upcoming month is crucial for the stock market, with a series of events that will impact it. These come at a time when stock valuations are high. I will discuss a market hedging strategy if things do not turn out perfectly for the “bulls.”

Stock Valuation Metrics
Valuation metrics for the stock market are financial ratios and indicators used to assess the value of a company’s shares relative to its earnings, assets, sales, or other key financial measures. They help investors determine whether a stock is overvalued, undervalued, or fairly valued compared to its historical performance, competitors, or the broader market.

The most commonly used metric for stock valuation is the price-to-earnings ratio (P/E). It measures the price investors are willing to pay for each dollar of earnings. It is calculated by dividing the stock price (or index level) by earnings per share (EPS). A high P/E may indicate overvaluation, but it can also signal potential for growth. Many companies in sectors like technology have high P/E ratios because investors bet on significant future earnings growth.

On the other hand, a low P/E may signal undervaluation, but it can also indicate expectations of slowing growth or other risks, such as declining profits, management issues, or competition. Low P/E ratios are often seen in companies with cyclical earnings that experience greater revenue volatility. When analyzing solely P/E, cyclical companies may appear undervalued during periods of high profits and overvalued when profits are weak.

Is the Market Overvalued?
Valuation metrics can also be applied to the entire market. An index like the S&P 500 includes a variety of companies: rapidly growing tech firms, consumer goods companies, and utilities, as well as cyclical firms like builders, energy companies, and industrial giants. Accordingly, these ratios often provide historical perspectives on whether investors are optimistic or pessimistic about growth and whether the stock market is “expensive” or “cheap” compared to its history, other asset classes, or international markets.

The P/E ratio of the S&P 500 is 26, which is not the highest level, but it is significantly above the average since January 1991.

Why Are P/E Ratios Rising?
We need more data to better understand whether current levels indicate that the market is “expensive.” Why have P/E ratios increased in the past? Have stock prices risen sharply, or have earnings declined? Do high P/E ratios correlate with lower returns for investors in the following months?

A quick review of the history of S&P earnings reveals a few things. First, peaks in P/E are typically accompanied by a sharp decline in earnings. Second, these massive declines are rare, and S&P earnings growth generally recovers after periods of economic stress. The most recent rise in P/E above 30 occurred when corporate earnings sharply declined during the pandemic. In late 2008 and early 2009, massive losses at financial institutions reduced overall corporate earnings, and consequently, the P/E ratio rose.

It is important to note that not every increase in the P/E ratio results from declining earnings. Sometimes stock prices simply rise too quickly. For example, the P/E reached 30 at the end of 1999/beginning of 2000, not due to a decline in earnings, but because of rapidly rising stock prices. Such is the case today—over the last two years, S&P earnings have grown by about 4%, while the S&P 500 index has increased by more than 60%.

No Room for Mistakes
The latest economic data has been positive. The employment and unemployment data from Friday was a remarkable example. The unemployment rate of 4.1% was below expectations, and job data exceeded forecasts. The labor market remains strong.

The only concern is that the enthusiasm of investors, which led to rising prices, leaves little room for error. If inflation data turns out to be high, it could harm expectations for future interest rate cuts.