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Mar 31 2013

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Would I Invest in the U.S. Stock Market at Current Price Levels?





 Your stomach is grumbling, and you’re aching for a slice of the best pizza in town. 

But how much will it cost you?  To understand, in relative terms, you’ll need to understand pizza-pricing history.  Why?  Because I’m going to relate pizza pricing to the stock market.

I’ve heard from an unreliable source that a box of pizza usually trades for a figure that’s twice the minimum wage.   When minimum wage was $5 an hour, a box of pizza could be had for $10.  It took 2 hours of burger flipping at McDonalds to earn enough to buy a cheese and pepperoni special.

Sometimes, however, pizza goes on sale.  In 1974, you could buy a yummy pizza for only 1.5 times minimum wage.  These examples are hypothetical, of course, but let’s assume that it cost $7 a box in ‘74.

In 1999, the price ballooned to 5 times minimum wage, costing $25 a box.

In 2013, assume that it costs $30 per box of pizza.

Yep, pizzas at $30 are selling at a record high.  Headliners looking for stories (and that’s what journalists do) write about how much pizzas cost, and they worry about a pizza price crash.  Are we paying too much for pizzas today?

If pizzas were priced, today,  at 2.5 times minimum wage, we would likely say no.

What does this have to do with the stock market? 




Everything.  The U.S. market is at an all-time high, but company earnings are high as well.  On average, the U.S. stock market, as measured by the S&P 500, has traded at 14.5 times earnings.  Because 14.5 times earnings is roughly the 90 year historical average, there were many years when the U.S. market traded above 14.5 times earnings, and many years when it traded below this level.

So…what’s the price to earnings ratio on the U.S. market today? 

You can check it by visiting any number of stock market websites.  Trying Yahoo finance reveals (as I write) a PE ratio of 14 times forward earnings for the S&P 500.  The total U.S. market index trades at the same level.  Closely aligned with the historical average, the S&P 500 is far below its all-time high.  In the year 2000, the S&P 500 reported a PE ratio exceeding 32 times earnings.

But what’s this about “forward earnings”? It’s a bit like quoting a box of pizza relative to what we think next year’s minimum wage is going to be.  A bit silly?  I think so.  Pricing the S&P 500 on March 29, 2013 (relative to last year’s earnings) gives us a higher figure:  18.35 times earnings.  Or, if measured by the Dow Jones Industrials, 15.95 times earnings.

Should you be freaking out?

 No.  Check out the historical price to earnings ratios for the decades 1991-2000 and 2000-2010.  The S&P 500 averaged 22.5 times earnings.  The higher the price to earnings ratio, the more expensive the market.

New investors adding fresh money to the U.S. market today are paying far less than they would have during most of the past 22 years.  And during the 22 years between 1991 and 2013, an investment in the S&P 500, including reinvested dividends, would have earned 637 percent.

The stock market will always be hitting new highs.  As corporate earnings grow, so will the price level of the market.  Does this mean you’ll make money every year?  No way.  Short term, as Benjamin Graham (Warren Buffett’s former professor) used to say, the stock market is a popularity contest; long term it’s a weighing machine.”

By this, he meant that increased earnings over time moves the stock market, long term.  And short term fear and greed (popularity) move the markets over the short term.

If you’re investing for the first time, and you’re afraid of the stock market’s recent rise, I understand.  But that puts you in the speculator category, rather than the investor category. 

So…would I invest a large, inherited sum today, if I were just starting out?  Absolutely. But I’d diversify it with bonds, a U.S. stock index, and an international index.  Let your allocation determine what you’ll buy each month, rather than allowing inaccurate headlines leading to speculation.

Years Median P/E Ratio

  • 1900-1910    13.4
  • 1911-1920    10.0
  • 1921-1930   12.8
  • 1931-1940   16.2
  • 1941-1950    9.5
  • 1951-1960    12.6
  • 1961-1970    17.7
  • 1971-1980    10.4
  • 1981-1990    12.4
  • 1991-2000    22.6
  • 2001-2010    22.4

Median S&P 500 P/E Ratios Source: Schiller, Robert. “Irrational Exuberance” [Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005]

 

 

 

 

 

 

 

 

 





About the author

andrew hallam

I'm a freelance finance writer, lucky enough to have been nominated as a finalist for two Canadian National Publishing Awards. I'm also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School, a book explaining how I became a millionaire on a teacher's salary, while still in my 30s. Working to empower people financially, I'm available to motivate and inspire people on basic retirement planning and index investing. I'm happy to comment on your questions, first, please read the Terms of Use.

Permanent link to this article: http://andrewhallam.com/2013/03/would-i-invest-a-lump-sum-in-todays-u-s-stock-market/

12 comments

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  1. avatar
    Adam

    I've been getting the S&P 500 PE ratio from this site that shows a value over 18.. http://www.multpl.com/table
    I wonder why there is such a big discrepancy between different sources?

    1. avatar
      Andrew Hallam

      Adam,

      I listed the S&P 500's trailing price to earnings ratio at 18.35, as of March 29, 2013. There's no discrepancy between that figure and the one you sourced. You probably just read my post too quickly. There's something called a trailing PE ratio and a forward PE ratio, as mentioned above. The trailing PE is the truth, and the forward looking PE is the projection based on next year's projected earnings.

      Cheers,

      Andrew

  2. avatar
    adam

    Doh! thanks Andrew. I always learn something from your posts.

  3. avatar
    Stig

    Andrew,

    I can see Adam's confusion with your recent post.

    In the post, you state: "You can check it by visiting any number of stock market websites. Trying Yahoo finance reveals (as I write) a PE ratio of 14 times forward earnings for the S&P 500." If you follow the link provided, the P/E listed is for "ttm" (trailing twelve months) and not forward earnings as stated in your post.

    If you go to Vanguard and look up the P/E for VOO (S&P) and VTI the P/Es that are listed (as of February 28/13) are 16.5 and17.4 respectively.

    At any rate, the main point is the trailing P/Es are not cheap as in recent times, yet they certainly are not in nose-bleed territory given historical averages/highs.

    Enjoy your posts.

    Todd

    1. avatar
      Andrew Hallam

      Thanks Stig,

      I should probably have given only accurate trailing PE information to prevent confusion.

      Cheers,

      Andrew

  4. avatar
    Blues

    Hi Andrew

    Thanks for all your knowledge sharing. I have actually read your book more than 9 months ago and liked it very much. However, I did not take any action hoping that the price will go down (the speculator in me!). Unfortunately, prices continued to trend up since then!

    This article serves as a timely reminder and I finally took action! I sold my limited US shareholdings and went into the Vanguard funds. Tomorrow, I will clear some of my SG shares and go into STI ETF. I still do not have the guts to go "ALL IN" as mentioned by you, but I will plan to add to the portfolio every month.

    My intended portfolio is as follow:

    VTI 20%

    VXUS 20%

    STI 20%

    Bond 30%

    Commodities 10%

    I still cannot find a suitable low-cost ETF for commodities. If you or any of your readers have any idea, I appreciate the sharing of information.

    Ok, a bit of over exuberance for finally taking action. Thanks again for your fantastic website and book, and keep up the good work!

    Cheers

    1. avatar
      Andrew Hallam

      Hi Blues,

      I'm glad to hear that you've decided to invest dispassionately, without speculation.

      Cheers,

      Andrew

  5. avatar
    Student of Investmen

    Andrew,

    Good article. I do have a few points that you may wish to consider when we use P/E ratio. First, I think P/E ratio should be used in the context of the overall economy. A P/E ratio of 22x in 2000 is due to the tech bubble that drove market sentiments way off their fundamentals. Then if I were to invest I would place a discount to the numbers, which is a matter of judgement rather than calculation.

    Second, we all advocate a global exposure to investing. I wonder if this numbers are still relevant for comparison with other stock indices like Singapore.

    Wonder what's your take on it

    Student of Investment

    1. avatar
      Andrew Hallam

      Hi Student,

      To be honest, I don't really think too much about what markets are expensive and what markets are cheap. By globally rebalancing a diversified portfolio, I'll never really get too caught up in a bubble. I'll sell rising asset classes to buy dropping ones over time. I think that's the best approach of all: establish a goal allocation and stick to it. It prevents any kind of speculation, and always allows you (quite mechanically) to be a little bit greedy when others are fearful and vice versa.

      Cheers,

      Andrew

      1. avatar
        Student of Investmen

        wise words indeed.. prudent asset allocation prevents you from speculation. Thanks for writing this post. Looking forward to more in future.

  6. avatar
    Manny Katz

    I have not been an investor most of my life. I'm now 75 and have low six figures just in cash and money market funds. A real estate loan is about to be paid off in part giving me lots of cash that I don't really want because of the tax bite. I've read your book as well as one by Dan Solin also an advocate of indexed funds. Would it really be wise to make a lump sum investment in a market which is at an all time high? You have pointed out in other posts that lump sum investments don't do so well. Your advice also hinges on one's willingness to invest in companies that are socially and environmentally irresponsible or even criminal, ala Wall Street.

    1. avatar
      Andrew Hallam

      Hi Manny,

      Are salaries at an all-time high? Based on your assessment of the market, you might suggest they are. However, we both know that salaries were higher fifteen and twenty years ago, based on an adjustment for inflation. When we measure stock markets, we need to measure them based on their relative level to earnings. Markets are at half the level they were at in 2000. Likewise, when we measure the prices of houses, we need to measure them based on how cheap or expensive they are, compared to median levels of income. Based on your rationale about the markets (extending to housing) you might suggest that houses are more expensive today (in the U.S.) than they were in 1988. But of course, houses are cheaper today than they were in 1988, relative to median incomes.

      I didn't know that I wrote about lump sum investments being a bad thing. Studies have shown that lump sum investments may be tougher emotionally, when markets fluctuate, but they are more profitable, generally, than dollar cost averaging. It's true what you say about capitalism though. If you dig, and measure any company by a moral standard, most will fail. I say that, because a moral standard for one person won't be the same as a moral standard for the next person.

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