This article was first published at the Humble Dollar
While the S&P 500's price-earnings (P/E) ratio has little predictive power if you look at returns over the next 12 months, it’s more important if you stretch out your time horizon to five years and beyond. What you pay has a significant impact on your likely long-run return—and that should be comforting for today’s buyers.
Recently, WisdomTree Global Chief Investment Officer Jeremy Schwartz shared a compelling graphic showing P/E ratios for dozens of U.S. and foreign stock market sectors. Whether you look at broad market segments or only at value stocks, it’s hard to find a hugely expensive part of the global market. For instance, WisdomTree shows a P/E based on forecasted earnings of just 13.8 for the Russell 3000 Value Index, a broad gauge of the U.S. stock market that excludes growth companies.
Morningstar concurs that markets look cheap. As of Aug. 31, the research firm boldly declared that all nine of the Morningstar “style boxes” were in undervalued territory. Its fair value estimate is based on a composite of some 700 individual stocks.
This is far different from the P/E picture at year-end 2020. Back then, according to FactSet, the S&P 500’s P/E ratio based on trailing 12-month earnings seemed stretched at around 31 times corporate profits. But as of this past Friday, large-cap U.S. stocks were trading below 20 times earnings—and below both their five- and 10-year averages. It’s reasonable to conclude that stocks are a good value today based on both trailing and forecasted earnings.
The bottom line: Rising corporate profits, increasing dividends and share buybacks, and the simple passage of time will eventually heal all stock market wounds. The longer the market trades sideways to down, the more compelling the valuation picture becomes—and the higher future returns will likely be.