S&P 500 P/E ratios suggest investors are betting on decades more of skyhigh profits

S&P 500 P/E ratios suggest investors are betting on decades more of skyhigh profits

A check in monitor in the Nvidia Corp. office in Austin, Texas. (Credit: Brandon Bell/Getty Images files)

Markets have taken an important turn over the past week that only a few are picking up on. Anthony Crudele, former S&P pit trader and financial pundit, summed it up perfectly when he posted “The market is currently in a ‘good news is bad, and bad news is good’ scenario. To me, that’s a bearish environment. If the market is focusing more on rate cuts than growth, it suggests the bulls are losing steam.”

This is what I worry the market has turned into: one that is overly dependent on loose monetary policy to backstop growth assumptions, with the Fed pumping money into the markets and boosting companies’ ability to grow. This is then used to substantiate record setting valuations. In today’s environment, you have the S&P 500 dominated by tech stocks that have never before in their entire history traded at these levels, even during the dot-com bubble.

There are those who would say that “this time is different” given the quality and magnitude of the growth potential, especially from the artificial intelligence boom. This certainly has some merit. However, I think it’s worth exploring things from a historical perspective whenever I hear those four famous words.

In his recent memo entitled On Bubble Watch famed investor Howard Marks takes a look back at his years of direct market experience. While he doesn’t say there is a bubble and leaves that for us to decide, he certainly does reinforce the importance of understanding the roots of investing.

“If there’s a company for sale that will make $1 million next year and then shut down, how much would you pay for it? The right answer is a little less than $1 million, so that you’ll have a positive return on your money,” he writes.

He then goes on to explain how price-to-earnings (P/E) ratio, or multiples, value the company’s worth into the future.

“Stocks are priced at ‘P/E multiples’ — that is, multiples of next year’s earnings. Why? Because presumably they won’t earn profits for just one year; they’ll go on making money for many more. When you buy a stock, you buy a share of the company’s earnings every year into the future. The price of the S&P 500 has averaged roughly 16 times earnings in the post-World War II period. This is typically described as meaning ‘you’re paying for 16 years of earnings.’ It’s actually more than that, though, because the process of discounting makes $1 of profit in the future worth less than $1 today. The current value of a company is the discounted present value of its future earnings, so a P/E ratio of 16 means you’re paying for more than 20 years of earnings (depending on the interest rate at which future earnings are discounted).”

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