Note that on all the graphs above, the values of all three P/E Ratios are significantly above their long-term averages. This is also true as of January 2020:
Table 13.4. P/E Ratios
What does this mean? Well, first of all, let’s see why the P/E Ratio I recommend to watch (the P/E Estimate) is so high. According to John Butters of FactSet, one year prior (January 18, 2019), the forward 12-month P/E ratio was 15.5. Over the following 12 months (January 18, 2019 to January 17, 2020), the price of the S&P 500 increased by 24.7%, while the forward 12-month Earnings Per Share estimate increased by 3.8%. Thus, the increase in P has been the main driver of the increase in the P/E ratio:
This means that prices of the S&P 500 stocks are overvalued which usually leads to a correction through a drop in S&P 500 share prices. We will have to watch the stock market to see if that is true.
In a recent New York Times article, Robert Shiller notes that his CAPE 10-year P/E reached 33 in January 2018 and was 31 at the time of publication (2020). He further pointed out that it has only been as high or higher at two other times, 1929 and 1999. In 1929, the high CAPE 10-year P/E immediately preceded the Stock Market Crash, during which the stock market lost 85% of its value. Likewise, in 1999, the high CAPE 10-year P/E ratio preceded another Bear Market; stocks lost 50% of their value. According to Shiller, some pundits blame exceptionally low interest rates for the stock market highs. However, states that low interest rates do not correlate well with the CAPE 10-year P/E Ratio. The opposite is also true; high interest rates do not correlate well with subsequent market crashes.
Shiller attributes the current Bull Market to what John Maynard Keynes describes as Animal Spirits. According to Shiller, he has seen a proliferation of narratives since 1960 of “going with your gut” as opposed to “using your brain” to make decisions. This attitude includes people like President Trump (“I have a gut and my gut tells me more sometimes than anybody else’s brain can tell me.”) and inexperienced entrepreneurs in Silicon Valley. It fuels the mania in the market. This is not the method of investing that Shiller advocates: “We have a stock market today that is less sensible and less orderly than usual, because of the disconnect between dreams and expertise (2009).”
However, no matter the outcome of the S&P 500 share prices, no one can accurately predict the timing of the market over the long term. For those investing in the market over the long haul, especially those who are putting regular amounts each month in their retirement plan, the best strategy is to stay the course. As we saw above, over the long term, the S&P 500 has returned on average 10% per year.
The S&P 500 includes five hundred companies, but six of them play an outsized role. These are:
- Meta (Facebook)
- Amazon
- Apple
- Netfix
- Alphabet (Google)
- Microsoft
David J. Lynch discussed this in a recent Washington Post article:
…with a combined market value exceeding $7 trillion, these six companies account for more than one-quarter of the entire S&P 500. That explains how so few companies can lift an index of 500 stocks. Since the S&P 500 is weighted by each stock’s value, or market capitalization, gains by these larger companies have a greater effect than gains by an equal number of less valuable companies (2020).
These six companies led the S&P 500 Index from a drop of 35% during the pandemic to a return to near its all-time high on February 12, 2020. It took about six weeks to fall into a Bear Market (defined as a drop of 20% or more from a previous high), and this was the fastest drop in history. The S&P 500 Index then climbed back in 126 days to where it was before the Pandemic Recession. This is likewise the fastest recovery from a bear market in history, according to The Wall Street Journal.