26 April 2018, 08:01 GMT
The magic number?
With the drop in equity prices we saw in the first quarter of this year, the price/earnings ratio - using a consensus estimate for earnings over the next 12 months - is now 16 for the S&P 500.
16 is the number I assume as the long-run fair value for US equities (which we use in our capital markets assumptions for solutions designing for our clients).
A common question I’m asked is whether the equity market is near end of cycle. My take is that it’s not near the end but at the end, and is now fairly valued.
However, this P/E ratio uses a one-year projection of company earnings. And the market is expecting significant earnings growth. To quantify this, I point out that the P/E ratio using current earnings is still above 20.
Earnings are key
The upcoming earnings season is therefore crucial. So far, the companies who have reported have mainly delivered. But any failure here will either return equities to an expensive status, or more likely trigger another price drop.
To be clear, I’m not viewing equities as cheap. But I do dispute that they are expensive. Of course a price drop is possible but if I saw that I’d view that as a buying opportunity as equities then would be cheap by my metric.
Much of my recent discussions with investors relates to their desire to protect the downside of their portfolios. They fear a significant price drop. My message is that it is expensive to protect the downside, and right now I’m not sure I see the tail event as any more likely than normal. More than half the time of the last 30 years the projected P/E ratio has been higher than current. Why now?
Source: Fidelity International, Eikon Datastream, March 2018
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