2022 has been seen stocks drop double digits from their peak. At its peak stocks were overpriced because there was too much demand. Part of that was from Covid stimulus and part of it was from cash that consumers saved from not being able to travel and spend on entertainment. During this rise, it may be easy to miss the warning signs of overheating. After the drop, are stocks ready to go up? In high school and middle school, the math concept of function was taught. For example y = 3x – 4. This example is a simple linear function. Functions provide a way to model something in the real world. If there exists a model, then it’s possible to make predictions. The stock market however is much more complex and can’t be modeled with a linear function or any function for that matter. The stock market result of the action of the experience and intelligence of all the market participants. The stock market is complex and acts more like a sine wave than a line. It has peaks and bottoms. Unlike a sine wave, there is no defined cycle or period and there’s no definite peak and bottom. In a free market as in free society, freedom is granted and there are free guardrails. An investor has infinite potential but he or she can also failed spectacularly. The cycles and periods vary wildly. While there’s no function that can model the stock market into the future, historical data can indicate when prices are out of its natural tendency or mean value. One metric to gauge the overall stock market is the PE ratio of the S&P 500. Our ability to recognize when stocks are overprice can save ourselves from painful losses and act as the guardrails in a high dangerous cliff.
Reversal to the mean
S&P 500 PE ratio tend to stay within some range. When you normally pay $5 for hamburger and now the restaurant changed the price to $15, you know it has gotten expensive and something isn’t right. Similarly when the S&P 500 PE ratio deviates from its typical value, we recognize it’s not normal and at some point it will eventually reverts back to the mean. This is known as reversal to the mean. This concept might be easier to explain with sports analogy. An NBA basketball player may typically score on average 3 3-pointers. In one particular game, he scores 10 3-pointers and then in the next game scores 13 3-pointers. Will he make 14 3-pointers in next game? No one can predict the very next game. However, over many more subsequent games, this player will surely return to his average stats.
S&P 500 PE Ratio
The S&P 500 PE ratio is calculated by taking the price of the S&P 500 and dividing the aggregate annualized earning of the companies in the S&P 500.
S&P 500 Shiller CAPE Ratio
A variation of the S&P 500 PE ratio is the S&P 500 Shiller CAPE Ratio. It was created by Nobel Prize winner in Economics Yale University Prof Robert Shiller. CAPE stands for Cyclically Adjusted Price-Earnings and is calculated by taking the current price of the S&P 500 divided by the 10 year moving average of inflation-adjusted earnings of the companies in the S&P 500. The key difference between the S&P 500 PE ratio is instead using the 1 year/ last 12 trailing month earnings, it uses the average of earnings over 10 years. Average over 10 years smooths out variations within the short term and provides a reasonable value of where the aggregate earnings of the S&P 500 should be at. The earnings are also adjusted for inflation so the earnings are comparable against the periods of different inflation and are not skewed by inflation. These adjustments lessen the impact of variations in earnings from the economy cycles and other one time special events. During recession the corporate earnings drop significantly. This can lead to a large change in PE. A large drop in earnings can make PE shot up. The S&P 500 Shiller PE Ratio allows the S&P500’s price to be evaluated and compared against other periods. Prof Shiller’s research showed the Shiller PE Ratio is inversely proportional to the price. That is when the ratio is high, the price of stocks tends to fall and when it’s low, stocks tend to go up.
The PE and the Shiller CAPE Ratio provide a metric of where stock prices should be relative to the companies earnings. The historical S&P 500 PE and Shiller CAPE data can give some guidance for when to exercise caution and reduce investment and when it might be an opportunity to buy more.
S&P 500 PE Ratio Chart
Here’s a link from nasdaq.com that provides S&P 500 PE chart from https://data.nasdaq.com/data/MULTPL/SP500_PE_RATIO_MONTH-sp-500-pe-ratio-by-month
The trend shows the S&P 500 PE ratio to be under 25. The times when it exceed 25 it eventually drop back below 25. When its drop below 15, it eventually rises back to the 20s. Latest available value is 9/30/2022 18.12. It recently peaked June 30 2021 at 45.60. A recent bottom was March 31, 2020 at 19.60 at the start of the Covid19 Pandemic.
S&P 500 Shiller CAPE Ratio
Here’s the S&P 500 Shiller CAPE Ratio chart:
https://data.nasdaq.com/data/MULTPL/SHILLER_PE_RATIO_MONTH-shiller-pe-ratio-by-month
The latest value available is 9/30/2022 and it’s at 26.84. It had fallen from a peak of around 39.98 in December 31 2021. On February 24, 2020 at the beginning of COVID pandemic, it hit a low of 24.90.