Concerns are growing that the stock market overvalued. A number of indicators, including the price-to-earnings (P/E) ratio, are at historic highs. The chart below shows the P/E ratio now and at previous bull market highs. The average P/E ratio at market tops is 19.2. Now, the P/E ratio is 25.6, well above that average.
The current P/E ratio is higher than seen at any other market top since World War II except for the 2000 top that ended with the Internet bubble.
P/E ratios are just one way to look at the market but they provide important insights into the market. Earnings, the denominator in the P/E ratio, are an important factor to consider because earnings growth is one of the most important drivers of long term trends in the stock market.
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In the short run, price trends can be driven by sentiment. That appears to be the case in the current market where sentiment has become increasingly bullish since the Presidential election.
The stock market has gone almost straight up since Donald Trump surprised political experts by winning the election. Since that November night, we have seen the S&P 500 gain more than 13%, an incredibly large gain over a relatively short period of time of about 16 weeks. We often think about market returns in terms of annual gains and we can easily convert the recent gains to an annualized rate of return. If this pace of gains could be sustained for a full year, the S&P 500 would gain more than 42% in 52 weeks in what would be one of the best years in market history.
However, large gains in a short period of time are often a sign of a potential bubble in the market and bubbles invariably end in crashes. That means we need to closely examine markets after large gains to determine if there’s a rational reason for the gains. If there is, we may not be in in a bubble and that would indicate we should consider increasing our portfolio’s exposure to the equity markets. If there isn’t a rational reason for the rapid gains, we should decrease exposure to limit the risks associated with a potential market crash.
In the current market, the reason for the rapid gains seems to be, at least partly, the fact that traders are expecting significant changes in corporate income tax policy. President Trump has said he is working with Congress to reduce the top corporate income tax rate from 35% to 15%. President Trump is a realist and is likely to make a deal to get some type of tax reform.
It seems unlikely he will get everything he wants but it seems likely corporations will enjoy lower rates.
Analysts at Standard & Poor’s have studied the tax environment and considered the range of possible outcomes for companies. Their report included an estimate that every 1% reduction in the corporate tax rate could add 1% to the earnings per share of companies in the S&P 500.
Now, analysts expect earnings per share (EPS) of about $133 for the companies in the S&P 500 in 2017. Each 1% reduction in the income tax rate could increase earnings by about $1.30. For example, if the President is successful and obtains a top tax rate of 15% in negotiations with Congress, this 20% decrease in the tax rate would increase EPS by 20%.
This allows us to revise the earnings estimates and develop price targets for a potential peak value of the S&P 500 based on history. As we saw earlier, the average P/E ratio at market tops is 19.2. Using that P/E ratio and this year’s estimated earnings of $133, we could expect the S&P 500 ratio to reach 2,554. This is about 7% above the recent price.
It is important to note that there is a difference in the P/E ratio using the historical earnings for the past twelve months as shown above and using projected earnings as we are now. Many analysts use historical earnings to evaluate the market. This allows for an easy, but overly simplistic, comparison to previous time periods and we can see how the current market compares to earlier precedents.
Markets are forward looking, rising when the economy and the outlook for earnings is positive and falling when the economy and the outlook for earnings are deteriorating. This means we should use forward looking earnings estimates when determining price targets. Of course, the targets are simply estimates of the market’s potential that may or may not be realized in the future. However, targets are useful in helping us understand whether the market is potentially undervalued or overvalued.
Despite the opinion of many analysts looking in the rear view mirror that the market is overvalued, forward looking measures indicate there is room for gains. As the chart below shows, there is actually a great deal of upside potential.
This chart assumes the analysis done by S&P is correct and that EPS increase 1% for each 1% reduction in the top corporate income tax rate. After revising the earnings estimate to account only for the changes in tax policy, we applied a P/E ratio of 19.2 to estimate the fair value of the market under different scenarios. The price targets are shown in the chart.
At a 15% tax rate, the S&P 500 could reach more than 3,060, a potential gain of more than 28%. This is the best case scenario under the current tax proposals. It is also an unlikely event since there will be negotiations and some degree of give and take on both sides.
You’ll notice in the chart that even a 5% reduction in the tax rate could result in a gain of more than 12% for the S&P 500.
The price targets shown in the chart above are most likely conservative estimates of the stock market’s upside potential. Tax reform in Congress would likely be extended to personal income taxes, decreasing the financial stress on families. A cut in the personal income tax rates for most families would almost certainly increase discretionary consumer spending. Higher spending would increase sales for the large companies in the S&P 500 and higher sales would add even more to a company’s profits. Tax reform would also be likely to increase consumer confidence and boost consumer borrowing and spending even more.
Lower income taxes would also signal that Congress is no longer gridlocked and additional action from Washington would be expected. Healthcare reform, infrastructure spending and other large programs would be possible and each of these actions could have positive impacts on the economy and large companies. These actions could all combine to push the S&P 500 to 3,000 and the Dow Jones Industrial Average to 26,000.
Price targets like this seemed unreachable in the minds of most analysts and investors just four months ago. But, after an election and signs of cooperation emerging among the different branches of government in Washington, large gains in the stock market now appear possible within twelve months. Additional gains could come after that assuming Washington is truly reformed.
Of course, downside risks are high if Washington remains gridlocked and unable to deliver on the promises of the campaign. Changes in tax policy appear to be the minimum investors expect. If we tax policy and high hopes are derailed, the market is, in all likelihood overvalued. A crash or a bear market are possible.
For the next months, we need to watch Washington to see of the bull market can continue.