The Price Earnings (P/E) Ratio

The P/E ratio is used by analysts to establish a company’s expected value. Multiplying either reported or projected earnings by this ratio gives an indication of this value. It provides a perspective on current stock prices.

The PE ratio is the price per share divided by earnings per share. It measures what the market pays for a dollar of reported earnings. While substantial effort is oftentimes used to project future earnings, as P/E ratios are not constant, this analysis must be done with care.

P/E ratios not only differ widely among companies, but also fluctuate significantly over time depending upon the company’s growth opportunities and the economic landscape. For example, while the P/E ratio of the S&P 500 over the past 90 years has been generally between 10 and 20 times; it has been as low as 6 times and, briefly, over 120 times. A high P/E ratio signals that a large portion of future earnings are expected to come from investment opportunities (growth).

P/E ratios for S&P 500 stocks have been increasing over the trailing 12-month period – from 22 to 26 times. Increasing P/E ratios help to explain the 21% return of the S&P 500, which is well above other market indices. Not surprisingly, the current P/E ratios of the so-called “Magnificent Seven” are above what’s typical, no doubt reflecting prospects for Artificial Intelligence (AI) – Amazon (84 times), Nvidia (82 times), and Tesla (61 times) stand out. These P/E ratios mean that the future impact of AI is a significant part of today’s stock price.

Market Review  

Stocks

Stock indices were mixed in January. Stocks traded on developed international markets were up a little less than 1% (EAFE Index) while emerging market stocks (MSCI Index) were off almost 5%. The S&P 500 Index was up almost 2% in January. This result is concentrated in stocks of just a few tech companies – the “Magnificent Seven” less Tesla that lost 30% due to a hiccup in earnings and concerns for the whims of Elon Musk.

Our emerging markets index was dragged down by losses in China and Korea, both down about 9%. These two countries make up 40% of the index. Over the past year, China was down 23%, primarily reflecting the economic turmoil from debt-financed real estate.

At their recent meeting, the Fed voted to keep the federal funds rate where it is. While the market’s initial response was negative, it has bounced back since. The current pattern of yields over the next year implies a drop of about 1% in short-term rates. However, not only is the eventual cut by the Fed uncertain, the impact on stocks depends on the extent to which any change is already imbedded in prices.

Bonds

Not much change in bond prices in January. Up a bit at the short end; down a bit for longer maturities.    The shape of the Yield Curve is currently downward sloping with short-term yields above longer-term yields, which has been the case for some time. To return to the more typical upward slope, either short-term rates must fall, or longer-term rates rise. Falling short-term yields seem more likely, but we’ll see.