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Amid the ongoing rally in equities, there has been much discussion about whether the market has become too richly valued. In that regard, it's important to place the market's current valuation (as measured by the price-to-earnings ratio [P/E] on the S&P 500® Index) into an historical context—specifically, how today's P/E stacks up against P/Es in similar economic environments in past years.
For equities, one of the most important macroeconomic factors influencing valuation is the rate of inflation, as measured by the Consumer Price Index (CPI). The rate of inflation largely depends on the overall economic climate—the CPI will rise more sharply during periods of rapid expansion, while price gains are subdued in flat or low-growth economies. It may be instructive to look at market P/Es during prior periods of comparable inflation.
Source: Bureau of Economic Analysis, FactSet, and Bloomberg. Data as of 11/21/13.
Past performance is no guarantee of future results.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Performance during other time periods may be different or negative. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Please refer to "Important Information" regarding the economic indicator data in these charts and index information.
Let's look at the current situation. First, as of November 21, 2013, the forward 12-month earnings per share expectation on the S&P 500, in the aggregate, is $119.30, based on analyst estimates compiled by FactSet. Assuming a price of around 1800 for the index (it closed at 1802.75 on November 26), the market's current forward 12-month P/E is approximately 15.1.
Second, core CPI (which excludes volatile energy and food prices) was higher by 1.7% on an annualized basis in October, according to a November 20 report from the Bureau of Labor Statistics.
Therefore, we should compare the current market P/E of 15.1 with the similar measures for time periods when inflation was near 1.7%. If we look at P/Es when inflation was in a range of 1–2%, we find that the average was 15.8. At its current P/E, the S&P 500 trades at a lower multiple versus similar inflationary periods.
It appears, then, that there is the potential for multiple expansion in the equity market over the next 12 months. For the P/E ratio to reach the average of 15.8 for similar time periods, the S&P 500 price, based on the current forward 12-month earnings of $119.30, would have to rise to 1885, from its current level of nearly 1800.
What about longer term? We can look to the inflation expectations priced into the CPI swap market to gauge where inflation is headed. Based on the Deutsche Bank 5-Year CPI Swaps Index, the market's five-year inflation expectation is 2.2%. If the inflation rate moves up to this level over the course of the next five years, the average P/E for comparable time periods would move up to 17.5.
Assuming continued economic expansion, even at a slow rate of growth, the stock market may have more room to rise than many expect. With the current forward 12-month earnings level of $119.30, the S&P 500 price would have to rise to 2088 to reach a P/E of 17.5, and that assumes no increase in expected earnings during the rise.
"Stocks, though pricier than they once were, likely retain enough value to support further gains, even in the current mediocre economic environment," said Milton Ezrati, Lord Abbett Partner, Senior Economist and Market Strategist.
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.
The price-to-earnings [P/E] ratio is a measure of valuation. It is a company's share price divided by its earnings per share. The P/E ratio can also be calculated for the companies in a stock index such as the S&P 500.
Earnings per share (EPS) is a company's earnings divided by the number of shares outstanding. This can also be computed for the companies in a stock index such as the S&P 500.
The Consumer Price Index (CPI) is a measure of inflation published by the Bureau of Labor Statistics.
In CPI swap contracts, one party agrees to make a payment at a fixed interest rate, which is based on the current, expected rate of inflation, and is compounded over the life of the contract. The other party in the CPI swap contract has agreed to make a payment at a variable interest rate, which is based on the actual rate of inflation over the life of the contract. The actual rate of inflation is measured by the cumulative change in the headline Consumer Price Index—including food and energy—over the life of the contract.
The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
The Deutsche Bank 5-Year CPI Swaps Index is provided by Deutsche Bank AG and is based in U.S. dollars, provides intraday price frequency, and is subject to a one-day lag. It is designed to track the performance of five-year CPI swaps.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.