Stocks Aren’t Cheap. They’re Just Not As Expensive.

Stocks Aren’t Cheap. They’re Just Not As Expensive.
Stéphane Renevier, CFA

over 1 year ago1 min

Mentioned in story

The valuations of S&P 500 stocks – as measured by the trailing price-to-earnings (P/E) ratio – have never dropped so far, so fast. The chart above shows the change in the ratio from one year to the next, with a negative value representing a drop from the year before, and vice versa. The metric is now down 10 points from 2021, but don’t be fooled: US stocks still aren’t cheap.

For one thing, valuations might’ve dropped significantly, but they’ve mostly just given back the gains they made during the 2020 rally, when they jumped by the biggest-ever margin from the year before. Consider too that the P/E ratio has almost consistently been rising since around 2010, as shown by all the positive territory in the red box. So while valuations have corrected somewhat, it’s still just a dent in the overall rise in valuations of the last decade or so.

For another, the metric has fallen more sharply than usual because company profits have stayed relatively high. That matters because the P/E ratio is calculated by dividing the current share price by profits over the previous four quarters. Put simply: when profits are high, the ratio falls. But as we’ve observed before, company profits are likely to drop in the next few months. And when they do, investors will send stock prices down to a level more fitting of those lower profits.

The takeaway from all this: stocks aren’t cheap, they’re just not as expensive – and they probably have further to fall.

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