The market’s math isn’t math-ing.
Investors are paying steep prices for stocks that don’t earn all that much in profits. It’s a shocking dynamic, considering that bond yields are surging and the Fed seems hell-bent on getting inflation down through a higher policy rate.
But if you’re buying certain stocks or crypto, you may not get what you paid for.
Grab your calculator — it’s time to run the numbers and talk about why prices and intrinsic value matter so much in this environment.
Running the numbers
Portfolio strategy is all about choosing the right investments for your goals, timeframes, and appetite for risk. Ideally, to satisfy that last part, you’d find certain stocks and crypto that give you an adequate return for the amount of risk you’re taking on.
Right now, that risk-return math is off. Stocks may be looking pricey relative to their earnings, a factor people typically consider when choosing where to put their money. Wall Street calls this “valuation analysis,” and some people make investing careers off of finding stocks that are trading at a discount relative to their potential (a tough endeavor, at this point in time).
To gauge just how expensive stocks are, look at the S&P 500’s price-earnings ratio. It’s a measure of where a stock or index is trading relative to the earnings it’s expected to generate over the next year. Right now, the S&P 500 is trading at about 18.2 times its expected earnings, according to Bloomberg estimates.
Think of it like a shirt at your favorite boutique. The materials used to make the shirt cost $1, but in your eyes, the shirt is worth $18 because of the design, style and label. Things you can’t see, but you definitely take into account when purchasing a shirt.
In a way, people see investments the same way. If investors feel good about the future, they may be willing to pay more for hot tech stocks or crypto, simply because they’re optimistic.
In a vacuum, stocks aren’t expensive relative to history, if you consider the 10-year average price-earnings ratio is 18.8. These days, however, 18.2 times may be a steeper price than you think, especially with inflation and recession worries still out there.
That designer label looks appealing, but it could be a knockoff.
Growth vs. yield
There’s also a crucial difference between today and most of the past decade. Bond yields are much higher, and that’s forced investors to think more about yield and income, and less about growth. In fact, the 10-year yield has averaged 2.2% over the past 10 years, a far cry from today’s 3.9% year yield.
That makes a difference when you’re looking at stock valuations. One way to compare the attractiveness of a stock’s potential return is through the earnings yield, or the implied return based on the company’s earnings. Right now, the S&P 500’s earnings yield is 5.5%, and the tech-heavy Nasdaq 100’s earnings yield is 4.3% — right around the 10-year yield.
Think of it this way: Would you rather buy a Treasury note that could yield you 3.9% a year, or buy a much riskier tech stock for a potential 4.3%? Don’t forget the fact that analysts expect earnings to fall more, which could lower the stock’s potential for return.
Like I said earlier, you might not get what you paid for. And with crypto, the sheer uncertainty of the space’s potential in a high-rate environment could make it expensive in someone’s eyes.
Plus, this risk-return imbalance has typically led to lower stock returns, historically.
Finding value
Now, there are legitimate reasons why people are paying more for stocks and crypto. Typically, when a bull market begins, people think stocks are worth more simply because the future looks brighter. Price-earnings ratios tend to jump before earnings actually rebound.
If you dig in deeper, you’ll see that not all stocks are looking pricey. Different industries can command different valuations, mainly because they have unique operations. Strip out big tech, and the S&P 500 has a price-earnings ratio of 16.8.
Drill down at a company level, and you’ll see that half of S&P 500 stocks have a price-earnings ratio less than their sector’s average. In fact, 75% of S&P 500 consumer discretionary stocks fall into that bucket. And in the tech sector, you could see price-earnings ratios from 7 to 63. There may be more stocks on sale than you think.
It’s also worth noting that bonds, stocks, and crypto are in a weird spot, too. We’re coming off a year when all three assets fell, even though bonds and stocks are historically inversely correlated. And all three are up noticeably this year. Can we trust signals from markets that are acting out of line?
Not adding up
Context aside, the math doesn’t seem to be adding up. Expensive prices could be a sign that you need to proceed with caution. Re-evaluate how much risk you’re willing to take on, and consider searching for names with better value relative to earnings.
And if you’re up for adventure, remember that there are ways to speculate in any type of market. Multi-directional instruments like options could be suitable for a higher-risk investor looking for an opportunity in a tenuous environment. They could also be a good choice if you’re feeling hesitant, but not willing to sell your position.
*Data sourced through Bloomberg. Can be made available upon request.