How Expensive Is the Market and What Is the Downside?

It appears we’ve run into a bit of volatility again this December. You will recall that last December brought a nasty surprise in the form of a 16% peak-to-trough drop during the month. Are we in for the same thing this year? Just how expensive are stocks, and where are they headed from here?

You can see from the chart below that the S&P 500 is currently trading above its average since the year 2000 on a price-to-earnings (P/E) basis. Specifically, the S&P 500 is now trading at about 17.6x the current consensus earnings estimate for the next twelve months compared to an average of about 15.8x since 2000. While this may seem like a big premium, the multiple is not even one standard deviation above the average over the time frame. For those of you who need a statistics refresher, one standard deviation above and below the average will include about 68% of the observations in the sample population. To put this in layman’s terms, the current P/E multiple of 17.6x is not wildly out of line with history. However, the average since 2000 includes some very high numbers during the initial few years of the new millennium. These P/E multiples were the result of the bubble. If we exclude those years the market does appear on the expensive side even as interest rates remain very low.

But there is also another factor we need to consider. In recent Market Commentaries, we discussed how the 2019 and 2020 earnings estimates for the S&P 500 have each dropped about 8% since September of last year. In order to gauge how expensive the current market is, we need to account for the possibility that the current 2020 estimates, which are about 10% above the current estimates for 2019, could be too high. We attempt to account for that uncertainty in the matrix below, which shows the sensitivity of stock prices to changes in both the P/E multiple and the growth rate in earnings in 2020. The two boxes that are highlighted in yellow reflect the current consensus expectation for S&P 500 earnings growth of 10% as well as the current S&P 500 P/E multiple of about 17.3x estimated 2020 earnings. If we assume that the P/E multiple stays the same but earnings growth decreases to about 4%, then the S&P 500 would have about 6%-7% downside. However, if earnings growth is indeed revised downward to just 4%, it seems more likely that the P/E multiple would contract a bit. In the event earnings growth declines to 4% and the P/E multiple contracts from 17.3x to 15.0x, the S&P 500 would have about 18% downside.

Are downward revisions to 2020 earnings estimates a foregone conclusion? Of course not, and neither is a contraction in the P/E multiple even if estimates do decline. It is also certainly possible that current earnings expectations could be too low rather than too high. Under that scenario, there is still room for P/E multiple expansion from today’s relatively high levels. However, a quick risk/reward analysis like this can be very constructive. In my estimation, this analysis reveals that today’s lofty earnings expectations for 2020 combined with relatively full P/E multiples could indicate that the risks somewhat outweigh the rewards over the near term. Does this mean you should go start selling out of all your stock positions? Of course not! Investing is a marathon and not a sprint, and nobody can predict the short-term gyrations of stocks with any degree of precision or consistency. Stay the course! But don’t be surprised if and when the next down-leg comes along. We can all remember last year’s pullback and May’s and July’s. They were unsettling, they’re over, and prices are higher. Investing is a long term proposition.