The S&P 500 gained 27% in 2021, and yet most US stocks are cheaper today than they were a year ago.
Sure, prices are up, as anyone who has reviewed their year-end 401(k) statement knows. Valuations, however, are down considerably. The S&P 500 began 2021 with a price-to-earnings ratio of 30.7, based on earnings reported in the previous 12 months. It ended the year with a trailing P/E of 23.6.
By that measure, stocks began this year 23% less expensive even after the exceptional 12-month performance.
If that sounds contradictory, allow us to simplify: The "e" in the stock market's P/E ratio grew faster than the "p." Collectively, corporate earnings for S&P 500 companies increased 65% in 2021, well above the 27% gain for the index.
The numbers, of course, need to be considered in context. Since 1989, the average year-end P/E ratio for the S&P 500 is 19.6, according to data compiled by Charlie Bilello at Compound Capital Advisors. Current valuations, in other words, represent a 20% premium to the 33-year average while at the same time looking like a bargain relative to January 2021.
Perhaps then the real question is this: Which number is more relevant?
Some argue the longer-term average encapsulates a wider variety of economic conditions. Others suggest an ocean's worth of central bank liquidity has rendered the majority of that history obsolete, or at least different enough to disqualify it as an appropriate reference point.
It's certainly true that historically loose monetary policy by the Federal Reserve has skewed what most investors consider to be a "fair valuation." It seems logical, at least in hindsight, that a historically high dosage of Fed-induced stimulus would lead to historically high stock valuations, which is exactly what happened. The 30.7 P/E from one year ago was the highest in this 33-year sample.
Here is what we know: Inflationary pressures have grown strong enough to force the Fed into action. Jerome Powell has already begun reducing Fed stimulus and interest rate hikes are coming, likely in March or April.
We have written countless times that Fed policy is the most significant driver (in modern times) of short-term market movements. We must therefore acknowledge that the recent shift toward less accommodating Fed policy will have a negative effect on asset prices.
Just how negative is anyone's guess, but the already sizable drop in P/E ratios can be attributed to two things: lower earnings growth and a less friendly Fed. The market is already pricing in at least some of the oncoming "Fedwinds."
As to whether current stock valuations should be viewed as attractive, consider this: The average year-end Fed Funds Rate since 1989 was 2.7%. Today, it's close to zero.
Even if Powell and Co. have the stomach to raise rates by 200 basis points (think: Eight separate hikes of 0.25% each), the rate will remain well below the 33-year average. It's appropriate to expect P/E ratios will remain higher than their historical averages in such conditions.
That doesn't mean stock prices can't go down. The S&P 500 and Dow Jones Industrial Average remain within a couple percentage points of their all-time highs. A steeper decline at some point is inevitable.
Momentum and sentiment also matter, and both have weakened since last fall. Still, the fact that valuations have come down significantly from a year ago reduces the downside for equities and should soften the blow whenever the next correction occurs.
Ben Marks is chief investment officer at Marks Group Wealth Management in Minnetonka. He can be reached at email@example.com. Brett Angel is a senior wealth adviser at the firm.