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]