Even though the price of the S&P 500 Index has fallen from the 3,300 level just a few months ago to 2,472 at the time of writing, for a 25% decline since the outbreak of COVID-19 has gripped the global economy, I do not believe that investors can conclude that the S&P 500 is now “on sale.”
When someone buys a share in an S&P 500 Index fund, paying $24.72 (or 247.20, or even $2,472 depending on the scaling), they are buying an asset that consists of America’s largest publicly traded companies that earns $1.33 per share. In other words, the S&P 500 is trading at 18.5x the most recent twelve months of earnings.
That is still above the S&P 500’s historical valuation of 15x earnings. In other words, for investors to obtain the 10% annual returns that are often discussed as the historical returns of the stock market, the inherent assumption is that the price of stocks are around 15x earnings at the start of the comparison period, the end of the comparison period, and businesses grow a little bit more than 7% annualized while paying out a little bit less than 3% annualized.
This 25% decline that we have experienced to date has resulted in the P/E ratio of the index shifting from 23x earnings (one of the ten most expensive years in the history of the stock market) to the current value of 18x earnings (which, at first glance, appears to be on the moderately overvalued side still).
My own view is that the 18x earnings valuation is subject to two important variables. First, it appears that the earnings of corporate America are currently contracting at a 15-25% rate according to the St. Louis Federal Reserve. If we take the 20% figure and apply that haircut to the $1.33 per earnings of the S&P, the earnings are really $1.06 right now. At a price of $24.72, that would suggest a P/E ratio of 23.
So we are back to where we started. Most likely, I suspect that the ten-year earnings per share growth of the S&P 500 will likely suffer a percentage point or so penalty as a result of the coronavirus, i.e. you can choose to think of the S&P 500 as an asset being purchasing at 23x earnings while likely to grow earnings per share 8-9% from the new COVID-19 earnings level, or you can think of it as purchasing an asset trading at 18x earnings (using the trailing figures) that is likely to grow 6-7% over the coming ten years from this point.
For someone who purchases shares of an S&P 500 Index Fund today, I would expect that the probabilities are high of receiving 9-10% annual compounding (if interest rates remain low in 2030 and there are no catastrophic or significantly adverse events occurring at that time) or the compounding will likely be in the 6-8% range in the event that interest rates rise from the current rock-bottom levels.
In short, much of the recent decline in the S&P 500 could be fairly classified as correcting a previously existing overvaluation, and to the extent that the S&P 500 appears to have seen its P/E ratio get cheaper, that will soon be met by lower earnings that suggests the decline is fairly justified.
The good news is that the S&P 500 does not have to be on sale to be a good investment. There is nothing wrong with buying into the stock market when it is “fairly valued.” After all, you still stand to triple your purchasing power with an investment in the index over the next ten years if interest rates remain low, and if they are notably higher or there is some type of adversity facing us in 2030, we are still looking a doubling of one’s purchasing power.
The even better news is that there are some stocks that are the equivalent of “babies being thrown out with the bathwater.” One profitable sector of the economy is trading at Great Depression levels. Another is trading at generation lows. Still another is trading at ten-year lows. So the opportunity is there for those who are willing to look for the lucrative individual companies. Otherwise, the S&P 500 now offers fair, though not historically better than average, terms.