In this article, we discuss the pitfalls of focusing on price when investing. Instead, we argue that we should focus on the value of an asset, not its price.
Price Tells Your Very Little
If you peruse the current financial news (January 2024), you’ll likely encounter headlines proclaiming, ‘S&P 500 closes at new record high’ or some variation. Reading such news can evoke a sense of euphoria, hinting at positive times ahead. But is this feeling justified? Does the S&P 500 reaching a new record high hold any meaningful significance?
There is a famous quote attributed to legendary investor Philip Fisher:
“The stock exchange is filled with individuals who know the price of everything but the value of nothing.”
The declaration of ‘S&P hits record high’ is a prime example of what Fisher cautioned against—it imparts no insight into the actual value of the stock market.
So, what is the value of the market?
Price-to-Earnings always trumps Price
A straightforward, albeit basic, method is to assess the Price-to-Earnings (P/E) ratio. The P/E ratio involves dividing the price of the S&P 500 by the weighted earnings per share of all its constituents.
A lower P/E suggests the market is ‘cheaper,’ while a higher P/E indicates it is more expensive. This metric provides a more nuanced understanding of the market’s current state than a simple glance at its price.
What is the current P/E of the S&P 500?
As per various data sources, the P/E is approximately 25.0. This implies that it would take 25 years to recoup your investment based on current earnings if you invested in the market today and earnings remained constant. Inverting that number gives us the earnings yield (akin to an interest rate) of 4%.
Firstly, a 4% earnings yield is not particularly attractive compared to inflation and alternative investment options. Secondly, the P/E becomes more valuable when compared with historical data. Let’s delve into that:
The graph above illustrates that with a P/E at 25.6, it surpasses both the 50-year median and 25-year median. (We opt for the median over the average to mitigate extreme outliers, as seen in 2009 when the market was evidently overvalued.)
Consequently, a 4% earnings yield appears less enticing, and historical data suggests the S&P 500 is overvalued.
However, caution is paramount!
The P/E is a static figure and can change rapidly. Various scenarios could unfold:
- The price could drop, lowering the P/E, which would be unfavourable for investors, or
- Earnings could increase, also reducing the P/E. Earnings growth is favourable for investors.
- Of course, both prices and earnings could increase.
Which scenario is likely?
Unfortunately, there’s no simple answer. It entails scrutinizing the constituents of the S&P 500 and analyzing their earnings potential going forward.
At Lockstep, this is precisely what we do with each of our investments. Adopting a conservative approach, we choose to invest when the valuation is below historical averages and when earnings have the potential to grow.
We’re not aiming to dampen spirits when the media rejoices over the market reaching all-time highs. However, such declarations can be misleading, and as investors, awareness is crucial. This brief analysis aims to shed light on the importance of looking beyond the surface and ensuring you’re not among those:
“who know the price of everything and the value of nothing.’”