Despite the fact that corporate earnings have come through very well, the stock market is weak. As a result, the S&P 500 is cheaper than it has been for many years, in terms of price/earnings ratios. There are different methods to value stocks, but perhaps the most common method is based on the price/earnings ratio. That is the price of a given company’s shares divided by the company’s earnings. We can also look at the average P/E ratio for the S&P 500 index going back in time as this chart does:
The blue line shows the price/earnings ratio for the S&P 500 going back to 1988. For me, there are two key pieces of information in this chart. At 12-14 or so, you can see that P/E ratios are about as low as they have been for many years. In fact, you have to go back to 1988 to find even modestly lower numbers. Second, it is clear that we have been in a grinding decline for P/E ratios since the 2000-02 period. In other words, P/E ratios are low by historical standards, but the trend may well go even lower.
If you want much more information on S&P 500 earnings going back over time, follow this link to the Standard & Poor’s web site and click on Index Earnings.
The next chart, also from the Crossing Wall Street web site (see link under each chart), shows the price action in the S&P 500 (black line) compared to earnings for the companies in the index (gold line).
This chart compares price changes in the index itself, dating back to 2005, with the ebb and flow of corporate earnings up to the present and then the chart goes forward a year or so with earnings estimates.
Share prices versus earnings
The key point I see from the data is that the S&P 500 has diverged from the earnings trend, suggesting a big change is coming. Either earnings are going to fall or stocks will eventually catch up to earnings. Assuming the numbers for corporate earnings are even close to being solid, then stocks really are cheap by historical standards. Unfortunately, given the rapidly-slowing economy both here and abroad, soaring corporate earnings seem rather unlikely for next year. So, it really comes down to your outlook. I think we could well go into a recession so I’m not looking for growth in corporate earnings. However, if earnings remain in the current ranges, then stocks are pretty cheap by historical standards.
In particular, I believe large multinational stocks such as Microsoft (MSFT), Johnson & Johnson (JNJ) and Eli Lilly (LLY) are cheap. For example, Microsoft has a P/E ratio of about 10 and a dividend yield of 3.20%. Johnson & Johnson has a P/E of 15 and a yield of 3.70%. Lilly has a P/E about 9 and yield of 5.4%. The following mutual funds and ETFs that invest in large established companies are also attractive.
- Vanguard Dividend Growth Fund [VDIGX]
- Vanguard Mega Cap 300 Value ETF (MGV)
- iShares Dow Jones Select Dividend ETF (DVY).
None of us knows what is coming — recovery, recession or even worse. However, I believe large, well-financed companies will survive and may well thrive in the next year or two or three. Therefore, I think investors should have a position in these cheap (by historical standards) stocks or in funds that own them.