A high P/E is not a stock market sell signal ⚠️
Plus a charted review of the macro crosscurrents 🔀
📉The stock market fell, with the S&P 500 shedding 0.6% to end the week at 6,051.09. The index is now up 26.9% year to date and up 69.2% from its October 12, 2022 closing low of 3,577.03.
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Valuation metrics like the price-to-earnings (P/E) ratio help us understand whether a security is cheap or expensive relative to history. And there’s some evidence that valuations can tell you something about long-term returns.
However, as TKer Stock Market Truth No. 6 reminds us: Valuations offer almost no signal as to what prices will do in the coming year.
This truth is particularly salient right now as forward P/E ratios are unambiguously high relative to history.
“[W]e think the stretched valuation environment is a product of enthusiasm around equities,” Schwab’s Liz Ann Sonders and Kevin Gordon wrote. “Yet, it's hard to argue that high multiples in and of themselves represent a risk to the market's near-term performance. Multiples can continue to move higher (as was the case in the late-1990s) and there isn't a strong historical relationship between valuation and forward performance.”
The forward P/E on the S&P 500 is a little above 22x. Sure, that’s high. And it’s a metric that’s preceded negative annual returns.
But as the chart below shows, it’s a level that’s also preceded very positive annual returns numerous times.
The big takeaway from the chart is that there is effectively no linear relationship between forward P/Es and one-year returns. In other words, the P/E ratio is a very poor market-timing tool.
“[T]he correlation between the S&P 500's forward P/E and subsequent one-year performance — going back to the 1950s — is -0.11, which means there is virtually no relationship,” Sonders and Gordon observed. “Perhaps less important is the correlation and yellow line; more important is the range of outcomes, such as two opposite instances in which the forward P/E was 25, but in one case was followed by a ~30% decline the following year and in another case a ~45% increase in the following year.“
Now there’s all sorts of ways to slice and dice the data as you try to find any sort of signal.
As we discussed in the Dec. 12 TKer, history suggests P/E ratios could expand further if the economy keeps growing. During periods where earnings growth is above average and monetary policy is accommodative, history says P/E ratios rarely fall.
There’s also the fact that S&P 500 companies are “less levered and higher quality” than they were historically, which justifies higher valuations.
By the way, lower valuations don’t always mean lower prices 🤯
TKer subscribers already know that it’s not uncommon for P/E ratios to fall even as prices are moving higher. See here, here, and here.
Ritholtz Wealth Management’s Matt Cerminaro made this less-than-intuitive observation in a recent LinkedIn post.
Even with the S&P 500 trading above 6,000 right now, the P/E ratio today is lower than it was in September 2020 when the index was at 3,500.
“How?” said Ritholtz Wealth’s Matt Cerminaro. “Because earnings are surging.”
The P isn’t the only variable moving in P/Es.
As this very long-term chart of S&P 500 quarterly earnings per share (EPS) from Deutsche Bank’s Binky Chadha shows, the E has historically tended to go up.
This means that as time passed, the denominator E has put downward pressure on the P/E.
Analysts expect earnings to keep rising in 2025 and 2026. That means even if prices go sideways, valuations could fall assuming these earnings forecasts are somewhat accurate. It also means there are scenarios where valuations fall and prices keep rising.
‘Math is not an edge’ 🧮
Nick Colas, co-founder of DataTrek Research, had a great anecdote in his Aug. 19, 2022 note:
Valuation alone is not enough. At the old SAC, rookie analysts often made the mistake of pitching Steve [Cohen] short ideas based on valuation metrics like P/E ratios or EBITDA multiples. His reply was always the same: “Everyone owns a calculator. Math is not an edge.”
In his Nov. 22 note, Colas referenced that anecdote as he discussed the data behind Wall Street’s 2025 targets.
“Valuations and the manifold uncertainties around the next 12 months make it easy to be bearish here but, in keeping with our mantra that ‘math is not an edge’, we remain positive and believe the S&P 500 can rally more than its long-term average over the coming year,” he said.
All that said, it’s totally possible we experience a year of poor returns where P/E ratios contract. If that were to happen, few would be shocked as it would arguably be “rational” behavior.
But markets have a tendency to not behave that way.
There are all sorts of good reasons why you might expect the stock market to go sideways or fall in the next year. But a 22x forward P/E ratio alone isn’t a reliable one.
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More on valuations from TKer:
Doubt about the P/E ratio's long-term signal for the stock market 🧠
Goldman Sachs destroys one of the most persistent myths about investing in stocks 🤯
The stock market's complicated evolving relationship with valuations 📈
Oppenheimer, SocGen, Fundstrat, Citi initiate 2025 targets 🔭
Last Sunday evening, Oppenheimer’s John Stoltzfus unveiled his 2025 S&P 500 year-end price target: 7,100. This is on $275 earnings per share (EPS) for the year.
“The quality of economic, business, consumer and job growth data from the start of the Fed’s rate hike cycle in March of 2022 through the initial cuts to its benchmark interest rate in September and November (and likely again this month of December) suggests further underlying support for the economy to sustain the current bull market,” he wrote.
On Monday, Societe Generale’s Manish Kabra offered a more modest outlook with his 6,750 target on $267 EPS.
“The three big positives under the new US government: 1) lower taxes to accelerate ‘reshoring’; 2) lower regulation with a focus on ‘supply side’ reforms; and 3) lower oil price to keep inflation in check,” Kabra wrote. “On the flip side, risks are tit-for-tat tariffs, causing inflation to rise and fiscal indiscipline, driving the cost of borrowing even higher. Trump 1.0 showed tax-cuts were announced before the tariffs to insulate the markets. Post the first 100-days, the Fed, inflation, tariffs and fiscal anxiety will feed into the market.“
Fundstrat’s Tom Lee, meanwhile, expects the S&P to rally to 7,000 in the first half of the year before settling at 6,600 at year end on $260 EPS. From his Dec. 10 note: “THESIS: TWO ‘PUTS’ MAKE IT RIGHT: – Fed ‘put’ as inflation eases and Fed focuses on supporting employment – Trump ‘put’ as White House implements policies to boost confidence & EPS – Re-allocation of investor capital from cash/bonds to equities.“
In a Dec. 6 note to clients, Citi’s Scott Chronert initiated his 2025 year-end target at 6,500.
“We believe post-election euphoria reflects confidence in longer-term growth drivers, but our structurally positive view on S&P 500 fundamentals does have a myriad of issues that need to be navigated,“ he said (via MarketWatch). “Ongoing soft landing and artificial intelligence tailwinds now interact with Trump policy promises, and risks. … Continued broadening beyond mega mega cap growth impacts is critical but an extended valuation starting point will be an ongoing hurdle.“
So far, we’ve been discussing strategists’ (top-down) forecasts. It so happens that the industry analysts (bottom-up) have price targets that are roughly in line with the median strategist’s target.
“Industry analysts in aggregate predict the S&P 500 will have a closing price of 6,678.18 in 12 months,” FactSet’s John Butters observed. “This bottom-up target price for the index is calculated by aggregating the median target price estimates (based on the company-level target prices submitted by industry analysts) for all the companies in the index. On December 11, the bottom-up target price for the S&P 500 was 6,678.18, which was 9.8% above the closing price of 6,084.19.”
For more, read: Wall Street's 2025 outlook for stocks 🔭
Review of the macro crosscurrents 🔀
There were a few notable data points and macroeconomic developments from last week to consider:
💰 Stock buybacks are high, but the level is close to average. From S&P Dow Jones Indices senior index analyst Howard Silverblatt: “S&P 500 Q3 2024 buybacks were $226.6 billion, down 4.0% from Q2 2024’s $235.9 billion and up 22.1% from Q3 2023’s $185.6 billion. The 12-month September 2024 expenditure of $918.4 billion was up 16.7% from the prior 12-month expenditure of $787.3 billion.”
“Buybacks as a percentage of market value declined to 0.515% from 0.537% in Q1 2024; the historical average (from Q1 1998) is 0.641%.“
For more on buybacks, read: Eye-popping, headline-grabbing market stats often aren't as extreme as they seem 🤦🏻♂️ and The truth about the hundred of billions of dollars worth of stock buybacks 💸
👍 Inflation remains cool. The Consumer Price Index (CPI) in November was up 2.7% from a year ago, up from the 2.6% rate in October. This remains near February 2021 lows. Adjusted for food and energy prices, core CPI was up 3.3%, unchanged from the prior month’s level.
On a month-over-month basis, CPI and core CPI were each up 0.3%.
If you annualize the six-month trend in the monthly figures — a reflection of the short-term trend in prices — core CPI climbed 2.9%.
For more on inflation, read: The end of the inflation crisis 🎈and The Fed closes a chapter with a rate cut ✂️
👍 Inflation expectations remain cool. From the New York Fed’s November Survey of Consumer Expectations: “Median inflation expectations increased by 0.1 percentage point at all three horizons in November. One-year-ahead inflation expectations increased to 3.0%, three-year-ahead inflation expectations increased to 2.6%, and five-year-ahead inflation expectations increased to 2.9%.”
The introduction of tariffs as proposed by president-elect Donald Trump would be inflationary. For more, read: Wall Street agrees: Tariffs are bad 👎
👍 Households feel better about their finances. From the New York Fed’s November Survey of Consumer Expectations: “The share of households expecting a better financial situation in one year from now rising rose to its highest levels since February 2020, while the share expecting a worse financial situation fell to its lowest level since May 2021.”
For more on household finances, read: Americans have money, and they plan to spend it during the holidays 🎁
💰 Household wealth is up. From Bloomberg: “Household net worth increased nearly $4.8 trillion, or 2.9% from the prior quarter, to $168.8 trillion, a Federal Reserve report showed Thursday. The value of Americans’ equity holdings rose $3.8 trillion. The value of real estate eased by almost $200 billion after sizable advances in the first half of the year.“
🏠 Mortgage rates tick lower. According to Freddie Mac, the average 30-year fixed-rate mortgage fell to 6.6%, down from 6.69% last week. From Freddie Mac: “The 30-year fixed-rate mortgage decreased for the third consecutive week. The combination of mortgage rate declines, firm consumer income growth and a bullish stock market have increased homebuyer demand in recent weeks. While the outlook for the housing market is improving, the improvement is limited given that homebuyers continue to face stiff affordability headwinds.”
There are 147 million housing units in the U.S., of which 86.6 million are owner-occupied and 34 million (or 40%) of which are mortgage-free. Of those carrying mortgage debt, almost all have fixed-rate mortgages, and most of those mortgages have rates that were locked in before rates surged from 2021 lows. All of this is to say: Most homeowners are not particularly sensitive to movements in home prices or mortgage rates.
For more on mortgages and home prices, read: Why home prices and rents are creating all sorts of confusion about inflation 😖
⛽️ Gas prices tick lower. From AAA: “Going nowhere fast is an apt description of the national average for a gallon of gas, which shed less than a penny since last week to reach $3.02. It has been close to the $3 level for five weeks yet faces stubborn resistance.”
For more on energy prices, read: Higher oil prices meant something different in the past 🛢️
💳 Card spending data is holding up. From JPMorgan: “As of 02 Dec 2024, our Chase Consumer Card spending data (unadjusted) was 1.4% above the same day last year. Based on the Chase Consumer Card data through 02 Dec 2024, our estimate of the US Census November control measure of retail sales m/m is 0.47%.”
From BofA: “Total BAC card spending per HH was up 0.6% y/y in Nov. We forecast 0.5% increases in ex-autos & core control retail sales. In the weeks of Thanksgiving and Cyber Monday, spending on holiday items was 6.1% higher than in 2023. In fact, holiday spending is running ahead of cumulative 2023 levels despite a delayed Thanksgiving.“
For more on the consumer, read: Americans have money, and they plan to spend it during the holidays 🎁
💼 Unemployment claims rise. Initial claims for unemployment benefits rose to 242,000 during the week ending December 7, up from 225,000 the week prior. This metric continues to be at levels historically associated with economic growth.
For more on the labor market, read: The labor market is cooling 💼
🤑 Wage growth is cooling. According to the Atlanta Fed’s wage growth tracker, the median hourly pay in November was up 4.3% from the prior year, down from the 4.6% rate in October.
For more on why policymakers are watching wage growth, read: Revisiting the key chart to watch amid the Fed's war on inflation 📈
👍 Small business optimism spikes. The NFIB’s Small Business Optimism Index surged in November. From the report’s commentary: “[C]learly a response to the presidential election. The election results signal a major shift in economic policy, particularly for tax and regulation policies, that favor economic growth.“
Notably, the more sentiment-oriented “soft” components of the index have converged with the more tangible “hard” components.
For more on the state of sentiment, read: The post-election sentiment sea change 🔃 and Beware how your politics distort how you perceive economic realities 😵💫
💪 Labor productivity inches up. From the BLS: “Nonfarm business sector labor productivity increased 2.2% in the third quarter of 2024, the U.S. Bureau of Labor Statistics reported today, reflecting no revision from the preliminary estimate. Output and hours worked were also unrevised, increasing 3.5% and 1.2% respectively. (All quarterly percent changes in this release are seasonally adjusted annualized rates.) From the same quarter a year ago, nonfarm business sector labor productivity increased 2.0% in the third quarter of 2024, as previously reported.”
For more, read: Promising signs for productivity ⚙️
🏢 Offices remain relatively empty. From Kastle Systems: “Peak day office occupancy was 61.3% on Tuesday 12/3, up 17.5 points from the previous Tuesday. Occupancy on Wednesday 12/4 also rebounded to 60.1%. The average low day was on Monday 12/2 at 47.3%.“
For more on office occupancy, read: This stat about offices reminds us things are far from normal 🏢
🍾 The entrepreneurial spirit is alive. Small business applications are up and remain well above prepandemic levels. From the Census Bureau: “November 2024 Business Applications were 448,758, up 5.5% (seasonally adjusted) from October. Of those, 157,678 were High-Propensity Business Applications.“
For more on what the business formation boom means, read: Promising signs for productivity ⚙️
📈 Near-term GDP growth estimates remain positive. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 3.3% rate in Q4.
For more on the economy, read: The US economy is now less ‘coiled’ 📈
Putting it all together 🤔
The long-term outlook for the stock market remains favorable, bolstered by expectations for years of earnings growth. And earnings are the most important driver of stock prices.
Demand for goods and services is positive, and the economy continues to grow. At the same time, economic growth has normalized from much hotter levels earlier in the cycle. The economy is less “coiled” these days as major tailwinds like excess job openings have faded.
To be clear: The economy remains very healthy, supported by strong consumer and business balance sheets. Job creation remains positive. And the Federal Reserve — having resolved the inflation crisis — has shifted its focus toward supporting the labor market.
We are in an odd period given that the hard economic data has decoupled from the soft sentiment-oriented data. Consumer and business sentiment has been relatively poor, even as tangible consumer and business activity continue to grow and trend at record levels. From an investor’s perspective, what matters is that the hard economic data continues to hold up.
Analysts expect the U.S. stock market could outperform the U.S. economy, thanks largely due to positive operating leverage. Since the pandemic, companies have adjusted their cost structures aggressively. This has come with strategic layoffs and investment in new equipment, including hardware powered by AI. These moves are resulting in positive operating leverage, which means a modest amount of sales growth — in the cooling economy — is translating to robust earnings growth.
Of course, this does not mean we should get complacent. There will always be risks to worry about — such as U.S. political uncertainty, geopolitical turmoil, energy price volatility, cyber attacks, etc. There are also the dreaded unknowns. Any of these risks can flare up and spark short-term volatility in the markets.
There’s also the harsh reality that economic recessions and bear markets are developments that all long-term investors should expect to experience as they build wealth in the markets. Always keep your stock market seat belts fastened.
For now, there’s no reason to believe there’ll be a challenge that the economy and the markets won’t be able to overcome over time. The long game remains undefeated, and it’s a streak long-term investors can expect to continue.
For more on how the macro story is evolving, check out the the previous TKer macro crosscurrents »
Key insights about the stock market 📈
Here’s a roundup of some of TKer’s most talked-about paid and free newsletters about the stock market. All of the headlines are hyperlinked to the archived pieces.
10 truths about the stock market 📈
The stock market can be an intimidating place: It’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes in it very quickly. But it’s also a place where thoughtful investors have long accumulated a lot of wealth. The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.
The makeup of the S&P 500 is constantly changing 🔀
Passive investing is a concept usually associated with buying and holding a fund that tracks an index. And no passive investment strategy has attracted as much attention as buying an S&P 500 index fund. However, the S&P 500 — an index of 500 of the largest U.S. companies — is anything but a static set of 500 stocks.
The key driver of stock prices: Earnings💰
For investors, anything you can ever learn about a company matters only if it also tells you something about earnings. That’s because long-term moves in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings. Over time, the relationship between stock prices and earnings have a very tight statistical relationship.
Stomach-churning stock market sell-offs are normal🎢
Investors should always be mentally prepared for some big sell-offs in the stock market. It’s part of the deal when you invest in an asset class that is sensitive to the constant flow of good and bad news. Since 1950, the S&P 500 has seen an average annual max drawdown (i.e., the biggest intra-year sell-off) of 14%.
High and rising interest rates don't spell doom for stocks👍
Generally speaking, rising interest rates are not welcome news for the economy and the stock market. They represent higher financing costs for businesses and consumers. All other things being equal, rising rates represent a hindrance to growth. However, the world is complicated, and this narrative comes with a lot of nuance. One big counterintuitive piece to this narrative is that historically, stocks have actually performed well during periods of rising interest rates.
How stocks performed when the yield curve inverted ⚠️
There’ve been lots of talk about the “yield curve inversion,” with media outlets playing up that this bond market phenomenon may be signaling a recession. Admittedly, yield curve inversions have a pretty good track record of being followed by recessions, and recessions usually come with significant market sell-offs. But experts also caution against concluding that inverted yield curves are bulletproof leading indicators.
How the stock market performed around recessions 📉📈
Every recession in history was different. And the range of stock performance around them varied greatly. There are two things worth noting. First, recessions have always been accompanied by a significant drawdown in stock prices. Second, the stock market bottomed and inflected upward long before recessions ended.
In the stock market, time pays ⏳
Since 1928, the S&P 500 generated a positive total return more than 89% of the time over all five-year periods. Those are pretty good odds. When you extend the timeframe to 20 years, you’ll see that there’s never been a period where the S&P 500 didn’t generate a positive return.
What a strong dollar means for stocks 👑
While a strong dollar may be great news for Americans vacationing abroad and U.S. businesses importing goods from overseas, it’s a headwind for multinational U.S.-based corporations doing business in non-U.S. markets.
Economy ≠ Stock Market 🤷♂️
The stock market sorta reflects the economy. But also, not really. The S&P 500 is more about the manufacture and sale of goods. U.S. GDP is more about providing services.
Stanley Druckenmiller's No. 1 piece of advice for novice investors 🧐
…you don't want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.
Peter Lynch made a remarkably prescient market observation in 1994 🎯
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. … Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go… They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That's all there is to it.
Warren Buffett's 'fourth law of motion' 📉
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
Most pros can’t beat the market 🥊
According to S&P Dow Jones Indices (SPDJI), 59.7% of U.S. large-cap equity fund managers underperformed the S&P 500 in 2023. As you stretch the time horizon, the numbers get even more dismal. Over a three-year period, 79.8% underperformed. Over a 10-year period, 87.4% underperformed. And over a 20-year period, 93% underperformed. This 2023 performance follows 13 consecutive years in which the majority of fund managers in this category have lagged the index.
Proof that 'past performance is no guarantee of future results' 📊
S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. For example, 334 large-cap equity funds were in the top half of performance in 2021. Of those funds, 58.7% came in the top half again in 2022. But just 6.9% were able to extend that streak through 2023. If you set the bar even higher and consider those in the top quartile of performance, just 20.1% of 164 large-cap funds remained in the top quartile in 2022. No large-cap funds were able to stay in the top quartile for the three consecutive years ending in 2023.
The odds are stacked against stock pickers 🎲
Picking stocks in an attempt to beat market averages is an incredibly challenging and sometimes money-losing effort. In fact, most professional stock pickers aren’t able to do this on a consistent basis. One of the reasons for this is that most stocks don’t deliver above-average returns. According to S&P Dow Jones Indices, only 24% of the stocks in the S&P 500 outperformed the average stock’s return from 2000 to 2022. Over this period, the average return on an S&P 500 stock was 390%, while the median stock rose by just 93%.
That Matt Cerminaro chart is amazing!
Thank you Sam. In 2023 'valuations were stretched.' The Mag 7 had a p/e around 50 (according to AI) yet those stocks especially and the S&P soared. Repeat in 2024. p/e and a good previous year's market is no reason to run away from stocks. If anything just rebalance to your normal asset allocation. Isn't that why we rebalance and have an investing plan?