DJIA 36,247.87 +.01%, NASDAQ 14,403.97 +.45% S&P500 4,604.37 +.41%, US Ten Year 4.23%, Oil $71.26
During the first full week in December stocks continued their move upward that began in November. Conditions look good for a continuation of this year-end rally. One of these is economic growth, with GDP for the fourth quarter up a particularly good 5.2%. Consumer spending remains robust, notwithstanding fears that buyers are using credit card debt to maintain spending. Meanwhile intermediate-term interest rates are declining. The ten-year Treasury note that was yielding over 5% just four weeks ago has since retreated to 4.25%. Stock market exuberance is being fueled by expectations of the Fed reducing short-term interest rates in the first quarter of 2024. But with the large jump in stock prices over the past five weeks, are they now over-priced?
Let us look at average S&P 500 P/E ratios over various periods of time. Since 1870 the average P/E ratio is 15.8. Since 1950 it has been 18, while since 1990 it is 23.3. Note how it has gone up over time. This is not a surprise, given the general trend of rising inflation that began with the gradual abandonment of the gold standard and the assumption of the responsibility for price stability by the Federal Reserve. The chart below shows the P/E ratio since 1990.
The positive relationship between interest rates and P/E ratios is well established. We know from history that the multiple increases when interest rates decline, and reverse direction when rate rise. We see that correlation from Ed Yardeni at yardeni.com.
Given the prevailing economic and fiscal environment over the past few decades it is appropriate to use more recent data to evaluate equity values. We see from the above that stocks are expected to trade at a P/E of about 18.5 over forward earnings, much less than the 23.3% of recent years. But with the S&P currently trading at over 27 times according to the chart below, is it not overvalued?
Courtesy: T. Row Price
Perhaps not. Much has been made recently of the “Magnificent 7” stocks of Alphabet (Google), Amazon, Apple, Meta, Microsoft, Nvidia and Tesla, and how their sky-high P/E ratios have distorted equity values as measured by the S&P 500 index. But look closely at the chart again. Removing these seven exceptionally large stocks gives the S&P 500 P/E ratio of only 17.5. So, stocks may not be overvalued. If expected earnings materialize and interest rates follow the path expected, even an expected P/E of 18.5 is well below the 23.3 average since 1990, and stocks should do quite well into 2024.