A Primer on P/Es and This Young Bull Market

Are stocks worth their price? With America’s S&P 500 and other world indexes hitting new highs, valuations—price-to-earnings (P/E) ratios in particular—are returning to headlines we see.^[i] Price-to-earnings ratios, as the name implies, compare a stock’s share price to its earnings per share. In our experience, many use these tools to attempt to divine whether stocks are cheap or pricey, all with an eye toward projecting markets’ next move. The trouble with this logic? Valuations don’t predict stocks’ direction, as we will show. Stocks some may consider cheap can always get cheaper and seemingly pricey stocks pricier.

Most focus we see lately is on forward P/Es—which compare prices to analysts’ estimates of earnings over the next 12 months. Many times, we see commentary on trailing 12-month earnings. We think forward P/Es make more sense, though. In our view, investors own stocks for their share of the future profits firms potentially generate because you can’t buy past earnings—they are already priced in. Note here, too, that we think the Cyclically Adjusted P/E (CAPE) ratio, which averages the last 10 years’ earnings—and then (in our opinion) bizarrely inflation adjusts that ‘E’ in comparison to the non-inflation-adjusted ‘P’—makes even less sense in this regard. (Inflation is an economywide price level increase.) The profits you earn from owning stock aren’t inflation-adjusted—they are regular pounds—and they aren’t averaged over 10 years.

We find valuations tend to hit headlines when they are high by some arbitrary standard, so it is no shock to us that the S&P 500’s forward P/E crossing 20 for the first time in two years roused some attention from commentators we follow.^[ii] But our research reveals valuations have never predicted future returns—including allegedly forward-looking forward P/E ratios. Exhibit 1 shows one way to see this. From May 2020 to January 2022, the S&P 500’s forward P/E exceeded 20. Yet the S&P 500’s return during that time was 63.8% in US dollars.^[iii]

Exhibit 1: No Problem Rallying With P/Es Above 20

Source: FactSet, as of 22/2/2024. S&P 500 price index and 12-month forward P/E ratio, 21/2/2019 – 21/2/2024. Presented in US dollars. Currency fluctuations between the pound and dollar may result in higher or lower investment returns.

There isn’t any magic valuation threshold stocks cross that tells you where they will go next, according to our analysis. Consider: As Exhibit 1 shows, forward P/Es soared from 13.1 in March 2020 to 23.4 in September 2020. But as Exhibit 2 shows, analysts were furiously slashing their 12-month forward earnings estimates—after stocks had already tanked, pre-pricing the actual earnings decline from COVID lockdowns, in our view. Then, stocks moved on. The S&P 500 troughed late that March and then rallied sharply before analysts reversed course and began raising their earnings estimates.^[iv] The P jumped whilst the E was still struggling. That wasn’t unique to 2020 but rather normally happens in a bear market’s aftermath, based on our research, which is why we think forward P/Es often seem elevated in bull markets’ early stages.^[v] To us, it is simple math, not a sign stocks are actually overvalued—it just means analysts are playing catch up as they slowly fathom the new bull market.

Exhibit 2: Stocks Price in Earnings Beforehand

Source: FactSet, as of 22/2/2024. S&P 500 total return, 12-month forward earnings-per-share (EPS) estimates and trailing 12-month EPS, 21/2/2019 – 21/2/2024. Presented in US dollars. Currency fluctuations between the pound and dollar may result in higher or lower investment returns.

The broader lesson here, in our view: Valuations say so little because stocks price in expected earnings in advance—well ahead of most analysts. We think they are exceedingly good at this. Exhibit 2 shows 2020’s February – March bear market sensed the lockdown-induced earnings drop two months before analysts did—and five months before earnings actually troughed. We find stocks didn’t wait—or care about elevated P/Es. Similarly, 2022’s bear market in US dollars started seven months before analysts had an inkling that corporate profits would struggle. Then the current bull market (navy line) started when stocks bottomed in dollars in October 2022, four months before earnings estimates (maroon) turned up and eight months before earnings reports (light blue) really registered a recovery.

In our view, the most important thing isn’t where earnings have been, but where they are going against what is priced in now—which present valuations echo. Notice trailing earnings remain below their 2022 peak, yet the S&P 500 is making new highs—apparently anticipating forward earnings’ ascent.^[vi] Current valuations, even those based on analysts’ future earnings projections, can only reflect present thinking and market movement, not what earnings will actually do. And our research shows that gap between reality and expectations is what drives stocks most.

Extreme moves in valuations can signal sharp sentiment swings, but even then, we don’t think they are a great timing tool, and there is no magic threshold. Because P/Es incorporate past prices—and past prices never predict, in our view—they won’t tell you where stocks are headed. We think forward-looking markets’ longer-term direction depends on what isn’t priced. We find how earnings evolve over the next 3 to 30 months based on new, incoming information versus present perceptions will determine stocks’ broader path, wiggles along the way notwithstanding.

Eventually expectations will likely get too high, setting up disappointment. But we seem to be early in that progression today, with sentiment only gradually becoming less sceptical. In our view, there is much more bull market to go before earnings expectations become impossible to reach.