The market is valued at a historically high level. With the NASDAQ and S&P 500 continuing an unending climb, increasing nervousness has entered into the analysts lexicon. The average PE ratio, after all, has been hovering in the range of Great Depression correction territory for quite some time. The question that is on most investors minds is when will this correction occur, and how steep will the drop be?
In a previous article I discussed why the historical valuation levels may have fundamentally changed. The short of it is that you can find an average for any price over time, but this does not require that price to be fundamentally constant. In other words, a PE ratio of around 15 is not an unalterable law of nature.
Still, supply and demand dynamics mean that PE ratios will fluctuate in the market. The question that investors should ask regards whether those ratios are too expensive given the current market conditions, not whether they are too expensive given a mathematically derived historical average. To say this more succinctly, is to say that we have yet to find a reliable crystal ball; the general outlook of the market is notoriously difficult to divine.
And while the demand of equities has increased due to the twenty-year shift from pension plans to 401k investments, our question remains "what is the current stabilized future value of money?" More precisely, what is the rate of return that will result in stabilized investment behavior (as indexed to the general PE ratio)?
401K and the shift in the PE ratio
The first thing you must take into account with 401K investing is that the investor typically receives an immediate return on the investment. Most businesses offer some form of matching funds. So if the historical expectation for return on investment results in a PE of around 15, we would expect that 401K investors would be willing to see a higher PE (and correspondingly lower rate of return) that takes into account the immediate return that they get (in most cases either 50% or 100% matching funds).
Although the tax code for 401K plans was formalized in 1978, for all intents and purposes it wasn't until the US government replaced their defined benefit plan with a hybrid 401K in 1986 that the vehicle began to gain significant footing as a target for mass investors. The stock market departed the realm of the rich and entrepreneurial and entered the vocabulary of society at large. Even in media, 1986 became the starting point of increasing focus on Wall Street (the blockbuster movie of that name was released in 1987).
When we look at the historical PE ratio, we will note that the period since 1986 has witnessed a sharp incline. When compared to the half-century preceding it, the PE ratio has been above the "green" range to an unprecedented degree. While some analysts have come to the conclusion that the historical PE average is fixed (and as such for every year and percent above the green ratio, there remains a year of drought in equal proportion below it) given the fact that the trend line coincides nicely with the advent of the 401K, we have a reasonable argument that a historical shift has occurred.
Rising Interest Rates
We have another chart to consider when sorting out a proper PE ratio against the future value of money. It is no surprise that interest rates on bonds will impact valuation of the stock market. Not only do higher rates bite into corporate earnings (thus degrading analysts future expectations), but higher interest rates in stable bond issuings becomes a more attractive investment alternative for both the expert and the amateur investor.
As you can see in the above illustration, the PE ratio has a generally decreasing trend as interest rates go up (although in the "healthy" 4-6% range there is little correlation, there is a definite trend above it). The market will largely take into account future earnings and dividend ratios against risk and the more stable bond opportunities. No surprise here.
As an aside, when we take into consideration the 10-year Treasury chart, we will notice that the PE ratio average will largely be dragged down by the series of high interest rate years depicted above the 6% level. On this chart, we note that a steep line appears to occur at 6.5%; PE ratios below this line largely exist at or above the 15 ratio (the lower ratios below 4% are likely a result of economic disturbances causing the lower interest rates).
With a relatively sound economy and reasonable corporate performance, we can see that the downside to a corrective turn will likely be quite muted unless/until interest rates crawl significantly above the 4% level (with 6.5% signaling danger territory). And in truth, given the obscene amount of debt that the US government has amassed, it would be quite difficult to sustain high interest rates on treasury notes (the only exception would be in high inflationary periods-i.e. the government is printing money).
While the market remains at historically high PE ratios, the balance of the evidence suggests that the market is not presently over-valued. An interesting note is that the historical correlation between 10-year Treasury notes and PE ratios actually seem to result in higher ratios as the notes swing from below to above 2% (which they recently have). Based upon history, we would generally not expect a downdraft to occur in a reasonably performing economy until we breach 4%, and even then we will note that the expectation of a sustained drop may not occur until we exceed 6.5%. This seems to be the point at which expert and amateur investors will begin to substantially rebalance their portfolios towards the bond market.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.