It’s amazing the kinds of arguments the habitual naysayers can come up with when pressed. Their latest take on the 17.7% rally that has unfurled over the past 14 weeks is that it only materialized because P/E ratios are on the low end of the “normal” scale, meaning investors aren’t really sticking their necks out — there’s not a lot of risk in owning stocks right now. Ergo, the rally still is ultimately doomed because few have any real “skin in the game.”
My response to the bears: Seriously? That’s the best argument you’ve got?
I actually sort of see the logic behind the criticism. But it’s a flawed logic because it ignores an important piece of the puzzle.
We’ll look at that other piece in a moment, right after we lay down some factual groundwork for the discussion — a context I have to add since the doubters like to draw conclusions based on assumptions.
What’s the Real Motivation?
As it stands right now, the S&P 500 is trading at a trailing 12-month operating P/E of 13.87. That’s not as low as the reading of 11.95 we saw when stocks were hitting bottom in September, but it’s still quite low in the grand scheme of things. It’s well below the 24-year average P/E of 19 (which is admittedly skewed upward by outrageous valuations from 2001 and 2009), and it’s still well under the long-term average P/E ratio of 15.5.
Let’s put it like this: It’s still about as cheap as stocks have been in the last couple of decades.
In that regard, the rally’s critics have a point: If you’re going to take a risk, the current (trailing) risk/reward scenario is as favorable as it has been since 1990. So why not take a swing, right? The plausible worst-case scenario is stocks just stall where they are and you tread water.
There’s the rub, however. The naysayers are arguing the only reason traders are even interested in the market right now is because stocks are so cheap, and risk is so relatively low as a result.
Fair enough, but I’ll counter with two not-entirely-rhetorical questions:
- How do you know investors don’t feel like they’re taking a risk by stepping in now?
- Based on history, if not at a P/E of 13.87, where should investors be buying in?
I’m not holding my breath waiting on any of the perma-bears to answer, so I’ll explain the argument and answer the questions from the other side of the table.
My Bullish Case
To be fair, my “investors aren’t blind to the risks” assumption has no more empirical support than the “investors are only buying because P/E ratios are low” argument does. The difference is, I’m willing to acknowledge I’m working with unverified data.
That said, I’d almost be willing to bet my lunch money if you asked 10 investors why they were tiptoeing back into stocks, low valuations would have little to do with it for eight of them.
My gut tells me the primary buying driver here is garden-variety fear of missing out on what might happen next against a backdrop of modestly improving economic growth. Ask around, though — traders feel like they’re taking a risk by being long regardless of valuations.
Click to Enlarge As for the ideal P/E level to use as an entry window for stocks, I did the legwork and only found fuzzy answers. The S&P 500’s P/E was at 14.5 in late 1994, but investors who avoided risk then missed out on a 200% rally between then and early 2000. The S&P 500 was trading at a ridiculously high P/E of 20.7 in January 2004, yet the market rallied 36% over the following three-and-a-half years. On the flip side, the market was trading at a palatable trailing P/E of 17.3 in October 2007, but a 50%-plus drubbing was just around the corner.
Point being, there’s no hard-and-fast historical basis for a P/E level being too low, too high or just right.
So what really drives buying and selling? While the correlation between the market’s P/E level and the S&P 500 might be a loose one, the correlation between the market’s direction and the direction of earnings is surprisingly strong. Said more directly, the most important factor in the market’s ebb and flow is whether earnings are rising or falling; the nearby chart comparing the S&P 500 to its per-share earnings verifies it. And I’m pretty certain that’s what’s driving investors into stocks now.
Bottom Line
While the “low P/E” argument has its merits, I’ve got enough faith in average investors to say most of them are looking beyond trailing valuations, knowing they are history. What they’re actually taking a chance on is continued earnings growth, which really isn’t a bad bet given the trend and projection.
