Think back to early 2020. The COVID panic was at a peak, with the S&P 500 falling 34%. The future looked grim. Who would have predicted the S&P 500 would end the year with a +16% return? The J.P. Morgan chart below demonstrates how hard it is to make any sort of prediction.
Red identifies the worst correction in each calendar year since 1980. In many instances, the equity markets recovered from significant declines in fairly short order(see grey bars for calendar year return).
Given the randomness of returns, predicting what the market will do prior to year-end is not knowable. What is valuable is knowing that S&P 500 corporate earnings, over long periods, have increased by an average of 7%-8% per year. Unfortunately, attaining future returns will be a bumpy ride. But as indicated below; as earnings increase the markets gain value over time.
S&P earnings (orange, right axis) S&P 500 value (blue, left axis)
So we know that earnings and index value are correlated, which leads to a big question I keep pondering........
If we knew with certainty what a company or index would earn in the future, could we forecast the price? In other words, what if analysts could make extremely accurate predictions?
Take the Royal Bank of Canada (RY) as an example. The stock traded in September at $127, with analysts estimating earnings this year of $11.25 per share. With these two numbers, we can calculate a current price/earnings (P/E) multiple of 11.29X. The question is, if we knew for sure that $11.25 was the correct earnings for 2022, is this multiple of earnings an accurate reflection of the Royal Bank's value? Turns out that the answer is not clear.
In March 2020 the general stock market sold off badly and the RY was valued at 7.3X earnings. Then the market went from depressed, to buoyant ( April 2021) with investors re-pricing RY to 15.8X earnings. In reality, did RY deserve to be poorly valued and then richly valued a year later? I think it is safe to conclude investors applied more art (emotion) and less science (math) to the stock price during this volatile period.
RY trades in a range of values; even if future earnings could be analyzed precisely, this would be only modestly helpful. What is more useful is knowing that on average over the past 5 years, RY has traded at 12.38 X earnings. With RY trading today at 11.28X earnings, it is valued in line with historical averages (not too hot or too cold).
The Royal Bank of Canada's range of past Price/ Earnings multiple
What about the broader market? Are index P/E multiples applied on a more consistent basis? The chart below is a rough representation of the S&P 500 over a very long time frame (data since the 1960s is more robust than earlier times)
S&P 500 Index Price / Earnings Multiple
Similar to the Royal Bank, the S&P 500 trades at a wide multiple of earnings. The Great Financial Crisis of 2007/2008 spiked the P/E to over 65. There is some logic to a wide range of multiples. When the economy is in a slump, investors reason that earnings will recover and that a high multiple today, will become a lower multiple over time.
I calculated (below) a range of P/E multiples and the corresponding possible S&P 500 index level. The results produce a range that almost defies any logic. With the S&P 500 currently trading close to 3,900, is it overvalued by 8% or undervalued by 125% using P/E as a price metric?
There could be an advantage to purchasing either the Royal Bank or the S&P 500 at the lower end of their multiple ranges. You might just participate in a multiple expansion, that adds to your return.
As a long-term investor one can rely on the strong likelihood that (over time) corporate earnings will grow. There are obviously many other factors that affect valuations that the equity markets take into consideration(stock yield, relative interest rates, economic considerations etc.,)
It seems one has to ignore both the Bull and Bear talking heads. Be comfortable that your asset allocation is appropriate and position for the longer term.
Thoughts, agreement/disagreement? email me at tim@mortonir.com
Please feel free to share if you know someone who would enjoy this content. Subscribe for future analysis at: mortonir.com
Tim Morton, CFA, is a retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com
Comentarios