Are Stocks Too Expensive? – First Coast Wealth Advisors

When debating whether stocks are cheap or expensive, most Wall Street analysts use the S&P 500’s historical price-to-earnings ratio to support their argument. The P/E ratio is a measure of how valuable corporate earnings are to market participants. The more valuable they are, the higher the multiple will be.

For the past 25 years, the P/E ratio using expected future earnings has averaged 18.4. That is if the S&P 500 were a single company, its price traded for more than 18 times its expected annual earnings. With today’s P/E hovering near 22x, it might appear on the surface that stocks are pricey relative to their earning power.

Making comparisons to long-term averages can be problematic unless one analyzes the data underneath a particular time period. Think of stocks as an available supply of goods, and think of cash and cash equivalents as available demand for those goods. When supply is tight and demand is high, what happens to prices? They go up. When supply is abundant and demand is lukewarm, prices decline. So, where are we on the supply/demand curve today?

The equity markets are shrinking. According to Investor’s Business Daily, the number of listed companies in the U.S. has declined from more than 7,000 in the year 2000 to less than 4,000 today. This isn’t specific to the U.S. The global supply of equity has been shrinking, too.

 

 

What are the reasons for the decline in publicly traded stocks?

1. Private equity and private credit investments are becoming more popular with (and accessible to) mainstream investors, diverting money away from publicly traded securities. In addition, private equity uses the capital raised from investors to take public companies private.
2. Share buybacks have grown as companies return more capital to investors.
3. The market for new issuance through Initial Public Offerings has been on the decline. According to Bloomberg, in the first six months of 2023, 39 U.S. based companies went public, while there were 47 proposed deals to take public companies private.

Shifting to the demand side of the equation, there is nearly $9 trillion currently held in money markets and cash alternatives.

 

 

Today, Money Markets alone contain roughly $6 trillion. In 2000 – when there were 7,000 common stocks – Money Market assets were $1.7 trillion.

While debate rages about how much of this cash pile is ultimately destined for longer-term assets like stocks, this much is true: It’s the largest amount of liquid assets in history. And its stewards will ultimately be selecting from a smaller pool of equity assets than in the past. Does this make the case for markets being able to justify higher than historical average P/E ratios? We think so.

 

The S&P 500 index is an unmanaged portfolio and individuals cannot invest directly in the index.