If you read my article a couple weeks ago, you already know I thought the market was going to set a new high before year-end. Well here we are and the market is sitting at all-time highs. I also said I thought the stock market was expensive, but it was expensive for a reason. It all boils down to interest rates being low and other asset classes also being expensive. My argument was that the one area of investment that looked attractive to me was stocks.
If you look at the stock market by itself without comparing it to other asset classes, it is definitely overvalued on a historical basis. However, if you look at the stock market and factor in where bonds are currently trading it becomes far less expensive. A bond’s value is determined by three basic factors. The first factor is the issuer’s financial stability. Second, the term of the bond or the maturity date. The third factor has to do with interest rates moving up or down. If interest rates increase, the value of the bond declines. If rates decline, then the value of the bond increases. Interest rates have been going down for over 30 years. It’s been a great period of time to own bonds.
Stocks, on the other hand, have many different valuation methods. The most basic valuation method is called the Price to Earnings ratio. I am sure many of you have heard the term P/E ratio. You simply divide the stock price by the earnings of the company for the last year and you will have the trailing P/E ratio. You can do the same to find a company’s forward P/E ratio by dividing the price of the stock by the projected earnings for the next 12 months. If you look across the different industry groups you will find that they all trade at different levels. For instance, financials will usually trade at a lower P/E than technology stocks. One way to identify a potentially good investment is to look for stocks that trade at a lower forward P/E ratio than their trailing P/E ratio. Stocks with lower forward P/E ratios than their trailing indicate the potential for growth. It’s not foolproof and there are many other factors to consider, but it is a very good starting point when you begin to research stocks you want to own.
The current trailing P/E ratio for the S&P 500 is 19.35. This is expensive on a historical basis, however, the argument I am trying to make is that if you compare this current valuation to interest rates, the market is not that expensive. Stock selection will be very important over the next 6 to 12 months. Do your research and be disciplined before making any investment decision. If you would like to discuss this topic further or have questions about your portfolio please call us at (772) 223-9686. Please visit our blog at www.fogelcapital.com for information on other financial related topics.