In market economies, price is everything. Prices serve as a shortcut to understanding the relative value — fundamental or otherwise — of an asset, and can illuminate supply and demand relationships. Prices are one of the purest forms of information a trader, investor, or economist can access, and at the end of the day, most (if not all) conversations about the stock market can be reduced to a discussion about prices.
What is the price of an asset? What should the price be? What price am I willing to pay for it? And, perhaps most importantly, is an asset currently over- or underpriced relative to fundamentals? (Or, if you are into price arbitrage, is an asset underpriced relative to what the market is willing to pay for it?)
On Monday, two major U.S. equity indexes, the Dow Jones Industrial Average and the S&P 500, hit fresh record-high prices above 16,000 and 1,800, respectively. Predictably, the conversation was focused on several questions: At this record price level, are stocks overvalued? Are equities overpriced relative to their fundamentals? Or are the new levels justified by robust earnings?
The answer to these questions have enormous implications. Overpriced markets stink of bubbles, and everybody loses when bubbles inexorably burst and prices crash. The financial crisis is still fresh in the memory of the market, and nobody is looking for a repeat. On the other hand, if earnings justify the prices, then equity bulls will be vindicated, and stocks could continue to climb even higher.
To be clear, the conversation surrounding the price level of the markets is more of a debate than anything. Bubble watchers have had one dubious eye on the U.S. Federal Reserve and quantitative easing round three since, well, QE round one was kicked off in the immediate wake of the financial crisis.
For the uninitiated, QE3 is a monetary stimulus strategy through which the Fed is purchasing agency mortgage-backed securities and longer-term Treasuries at a rate of $85 billion per month. The primary purpose of this program is to drive down longer-term interest rates — reduce the cost of credit — and thereby encourage the kind of borrowing and spending activity that drives economic activity.
This is packed with pros and cons, and one of the side effects is that all of this “easy money” creates higher equity valuations. Historically, there has been a fairly strong relationship between QE and market rallies. When the Fed puts its foot on the gas, stocks climb — when it eases, stocks retreat. Easy access to credit is a stimulant for the financial markets, and many observers have likened QE to a drug that the market has become addicted to.
So are the markets just high off of QE and wrapped up in a drug-induced rally? The answer is unclear, but we can look at some data that helps reduce the opacity.
Since price is relative, it is often more constructive to look at the price-to-earnings ratio of an equity — or, in this case, of the entire index — in order to gain some insight into what’s actually going on. What are investors willing to pay for every dollar of earnings?
On Monday, the total 12-month earnings per share of the S&P 500 was about $91.20. At a price level of 1,800, this yields a price-to-earnings ratio of about 19.79. That is, investors are willing to pay about $19.79 per dollar of earnings for the average stock in the S&P 500.
Now the question is, is this a lot? The answer, as mentioned, is not very clear. Whether this price-to-earnings is a lot depends on the time frame you’re looking at. Compared to September 2011, this is expensive. Compared to September 1997, it’s cheap. Below is the price-to-earnings of the S&P 500 over time.
At a glance, it’s easy to see that the price-to-earnings spikes right before a market crash. That’s the bubble inflating and then bursting. Price-to-earnings spike either when prices skyrocket or earnings collapse.
Another way to evaluate the price of the market is to look at what’s known as the Shiller price-to-earnings ratio, or the P/E 10. The P/E 10 calculates price to earnings using the real (inflation-adjusted) earnings of the index averaged over the past 10-year period. This flattens the ratio and helps moderate short-term fluctuations.
You can see that the P/E 10 behaves much differently during a crisis than the normal price-to-earnings ratio. The P/E 10 is also currently running higher.
Lastly, we can look at just the earnings produced by all of the companies in the S&P 500 index. These have pretty much regained their pre-crisis levels.
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