The Dangerous Assumption Fueling S&P 500's P/E Ratios
Jesse Felder | Mar 16, 2023 05:30
After the painful decline in stock prices last year, many investors have concluded that this now represents another terrific buying opportunity. And if you look just at earnings-based valuation measures, you could be forgiven for thinking that, while they may not be inordinately cheap, equity valuations are no longer extreme.
The forward price-to-earnings ratio shows the S&P 500 trades at a multiple of around 17, near its average over the past two decades.
What this measure obscures, however, is the fact that the profit margins supporting those earnings are still obscene. Moreover, estimates assume the recent decline in margins will soon reverse and that they will return nearly to record highs.
Certainly, there are at least a few reasons (like the strength in the dollar, interest rates, and oil prices over the past couple of years) to be skeptical of this optimistic analysis. Rapidly rising labor costs typically lead to margin declines greater than that we have already seen, and labor costs have already risen faster than at any point in the past thirty years.
If profit margins continue to fall over the course of this year rather than reverse higher as expected, the denominator in those forward price-to-earnings ratios could decline dramatically, revealing the fact that equity valuations were never really all that reasonable in the first place.
They only appear that way today as the result of some specially heroic assumptions on the part of equity analysts.
Get The App
Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.