If you think the stock market is overvalued or undervalued, look beyond broader indices like the S&P 500 Index. Price-to-earnings ratios of different sectors might offer value.
There’s no doubt it can be difficult to make investing decisions in today’s stock market. With major averages like the S&P 500 Index (SPX) making new highs and interest rates at low levels, some investors may be wondering: Where’s the value in today’s market, and what are the risks with the SPX trading at such heights?
That’s understandable. The SPX has been in a steady rise since the depths of the financial crisis back in March 2009. Back then, the SPX fell to a low of 666. Since then, it rallied all the way up to about 3,393 right before the pandemic crash. But after a few months it recovered and is now trading close to 4,450. There have been a few corrections along the way, but for the most part it’s been a consistent climb (see figure 1).
FIGURE 1: S&P 500 (SPX) MONTHLY 2009-2021. The SPX has risen by about 564% from the low of the financial crisis in March 2009. Data source: S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
When the SPX rises by more than 3,700 points since 2009, it’s only natural for investors to question if it’s overvalued. What are the risks after this 12-year bull market? Looking at the price of the SPX alone isn’t enough to answer these questions. This is where earnings need to be considered in relation to price when considering whether the market is overvalued, undervalued, or at fair value.
The relationship between earnings and price forms one of the most basic and widely used ratios to measure value: the price-to-earnings (PE) ratio. The numerator in this ratio is the price of the SPX. The denominator is earnings. In the case of a group of stocks, like the SPX, it’s the combined earnings of all companies in the index.
Generally, there are two different earnings figures available: actual and estimates. Actual earnings are reported by companies, and because the numbers come from the past, some investors say PE ratios based on actual earnings are “rear-looking.” In contrast, PE ratios based on earnings estimates are “forward-looking.” However, it’s important to realize that these estimates change as companies report new earnings every quarter.
You might be wondering: Which PE ratio should I use? It’s not really that one PE ratio is better than the other, but it’s important to understand the differences and identify how a given PE ratio is calculated when you’re doing this type of research.
So, now that you have a little more insight into PE ratios, let’s take another look at the SPX from a valuation perspective. We’ll also look at the 11 S&P sectors. And we’ll look at the PE ratios using actual and earnings estimates.
But before diving into the sectors, let’s look at some historical context for the SPX’s actual PE ratio, which was at 30.99 through late June. The average actual PE ratio of the SPX, going back over 100 years, is usually about 15 to 16.
At the low end of the SPX’s historical PE range, actual PE ratios fell to single digits around 1920, 1950, and 1980. At the high end, during the peak of the dot-com bubble in 2000 and subsequent bust in the following years, the actual PE ratio rose to 46. The fallout from the financial crisis, and a sudden and sharp drop in earnings, caused the SPX’s actual PE ratio to briefly spike all the way up to 123 in 2009.
Although the SPX’s PE has been trending upward around 31, it’s still significantly higher than the long-term average of about 15 to 16. So, it’s understandable why some investors might be calling current valuations of the broader market into question. However, as we saw in the table, there’s a wide range of valuations when looking at the SPX from a sector point of view.
Arguably, some sectors might offer some value even when considering the SPX has been trading near all-time highs. Keep an eye on fundamentals. For example, an economic recovery could spur investors to rotate out of safe havens and into riskier assets. In 2020, we saw U.S. growth stocks outperform many other categories. But will we see a shift in investing preferences during the second half of 2021? The economy and how the pandemic evolves will likely play a big role in investors’ decisions.
It’s a good idea to keep an eye on equity valuations, corporate earnings guidance, and economic data such as employment and retail sales. This will help gauge shifts in investor preferences. But keep in mind that past performance doesn’t necessarily guarantee future results.
The takeaway is this: If you’re looking for value, start your search at the sector level. The valuations of the major averages, like the SPX, can be skewed by just a handful of sectors or even enormous stocks. But individual sectors might still offer some bargains.
Use a stock screener to narrow selections based on sectors.
Log in to your account at tdameritrade.com > Research & Ideas > Screeners > Stocks.
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