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The Most Common Question

07/28/2016

Everybody lives in fear . . . of something!  Investors live in fear of sudden market crashes (even though each has been followed a recovery).  They have vivid memories of the Crash of 1929, the Crash of 1987, and the Global Financial Crisis of 2008/9.  As long as the bulls run, there will be an increasing fear that “the end is near.”  It is the most common question I receive.

The shorthand method of explaining whether the market is over-priced is by examining PE ratios.  A Price-Earning ratio is the market price of a stock divided by the earnings-per-share of that stock.  For example, if a stock is earning $10 per share, while the value of that stock is $100, then the PE ratio is ten.  Aggregating all those individual stocks into one number is a reasonable indication of whether the stock market is over-priced and likely to soften.  (While analysts have devised variations of a PE ratio, this is still the most common shorthand method.)

Historically, we’ve said the market is overpriced when the PE ratio rises above the 16 – 18 range.  Today, it stands at 20, making it overpriced.  However, the PE ratio for the energy stocks is a whopping 53.  That means the fall in stock prices of oil companies has not kept up with the fall in oil prices.  There is no equilibrium in the energy sector, causing an abnormally high PE.  This skews the average PE higher for the whole stock market.  If you factor out the energy sector PE, the overall PE ratio is only 16.

So, the market is not overpriced.

That does not mean the stock market will not soften, because IT WILL . . .  at some point.  It will strengthen and soften mildly with the normal ebb-and-flow of investment dollars sloshing around, but I don’t believe the stock market will soften because it is overpriced . . . today!

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