Investment Outlook: Fourth Quarter 2020 Don't Judge a Stock by its Index
It is easy to say that the stock market is expensive based on many of the typical valuation methodologies - Price-to-Earnings or P/E being the most widely used measure. Stocks are expensive when compared to historical averages. Over the last 25 years, the S&P 500 traded at an average forward P/E ratio of 16.5X. The index at year-end traded at a forward P/E of 22.3X. While this is well above where history tells investors stocks should trade, there far more to the story than is first revealed.
The “E” in forward P/E is the earnings for the next year as estimated by Wall Street analysts. 2021 is expected to be a year of economic recovery by most of Wall Street but for many industries, the expectations of a full recovery will not happen until 2022 or 2023. This has caused the overall earnings expectations to be constrained over the next year which reduces the “E” and causes the ratio to balloon higher. Investors are willing to look past the next twelve months to when earnings are likely to recover and as such are willing to pay these higher multiples right now.
It’s also important to understand that stocks are not homogenous and the characteristics of most indices are dominated by the largest companies. Take for example the S&P 500, the ten largest companies trade at 33.3X next year's earnings, while the remaining stocks (about 490) trade at a far more reasonable 19.7X next year’s earnings. The discrepancy between the top ten and all the others has much to do with the remarkable performance of technology in 2020 along with the more subdued performance of the other sectors. The spread between the P/E multiple of the top ten stocks compared to the remaining stocks is the highest its been in nearly two decades. This fact alone could raise fear in some investors, seeing as the last time the spread was this wide was the dotcom bubble.
The good news is that the largest companies are on a far more stable footing than their counterparts, twenty years ago. These companies have established business models that create real economic profit, unlike the top ten during the dot-com bubble.
With the wide disparity in valuation and how far along companies are in the COVID recovery, there are many different strategies investors will use in 2021. Some will continue to invest in the very richly valued stocks which have performed so well in the last year because of the belief the good times will continue. Others will look for value in the stocks that are just beginning the recovery. These are the stocks that might not appear expensive and have more room for growth as things normalize. The good news is that most stocks will do well as we come out of the pandemic economy and return to a more normal world.