Stock Market in 2020: “What’s a P/E Ratio?”

Jonas Elmerraji, CMT

A few years back, Apple ran an iPad ad that hilariously infuriated some people.

Apple_ad_rage

From Business Insider:

The ad shows a kid, age unknown, retiring to her grassy backyard after a day of hanging out with friends and doing school projects with her iPad Pro in what appears to be Brooklyn. A neighbor asks her what she's doing on her computer.

"What's a computer?" the kid replies.

Maybe Robinhood could do their own version of the ad in 2020.

Except the question would be “What’s a P/E ratio?”

I was looking at some charts from JPMorgan Asset Management’s always excellent quarterly Guide to the Markets over the weekend, and was struck by how fast this market has gone from just plain frothy to downright historically expensive:

SPX_forward_PE
Source: JPMorgan Asset Management, Q4 2020 Guide to the Markets

As of the end of September, the S&P’s forward P/E ratio sits 1.6 standard deviations north of their 15-year average. More incredible is the fact that the S&P nearly touched the -1 SD line during the COVID-19 crash back in March – and now, the big index is sitting up around levels not seen since the dot com bubble.

There are some limitations to using forward P/E as a gauge of fair value. But the forward return picture is pretty clear, especially with a 5-year forward look:

FwdPE_vs_Fwd5yrreturns_SPX
Source: JPMorgan Asset Management, Q4 2020 Guide to the Markets

Looking at where we are in the cycle today, the current forward P/E on the S&P 500 implies a slightly negative subsequent 5-year annualized return.

That’s maybe made a little more jarring when you consider the context in 2020: in the last decade, the average annual price return for the S&P 500 has been a whopping 11.81%.

In that stretch, there’s only been a single year (2018) when the S&P closed its books down more than a full percentage point.

In other words, if the market suddenly does start caring about valuations it could be a tough environment to be long in.

Does that mean that investors should be rushing to get out before the next crash?

No way. The big differentiator this time is the Fed – and the central bank’s willingness to both take unprecedented steps to keep the economy stable in 2020 as well as overly use equities as a gauge for how well they’re doing their job changes the calculus a lot.

Likewise, as we already saw this year, what’s expensive may be pretty expensive right now, but what’s cheap is actually very cheap on a relative basis. (I’ll update these numbers soon – stay tuned.)

Does it make sense for investors to be a little more on edge with valuations where they are right now? Absolutely.

But ultimately, you’ve got to trade the market you’re in, not the one you were in five or ten years ago. At some point, valuations will matter again, investors will poo-poo the irrational exuberance of speculators in 2020, and we’ll probably see the kind of difficult-to-swallow returns that JPMorgan’s charts imply.

But that day is not today. Or likely tomorrow. Or next month.

Right now, this market doesn’t know what a P/E ratio is. Invest accordingly.

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