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  • Writer's pictureSteve Coker, CFP

Valuation Check

With the S&P 500 rallying more than 8% since November 4th, several of our clients have asked whether the market is overvalued and in ‘bubble’ territory. 2016 was certainly a great year for stocks and valuations are much higher than they were a year ago, so it is worthwhile to question today’s valuations. Yet, as we look at the underlying data, we find that there are in fact reasons that stocks have jumped and while stocks are not cheap they are roughly in line with historical norms. Moreover, there are reasons for the increase over the past few weeks as the market looks forward to 2017.

One basic measure of stock market valuation is the Price Earnings Ratio or simply “P/E Ratio”. This measurement essentially communicates the price of every dollar of earnings, so a higher ratio indicates a higher valuation for stocks. As of last Friday, the S&P 500’s P/E ratio over the trailing 12-months of operating earnings was 19.2x. This ratio is slightly higher than the historical average of 18.5x, and at first look, indicates a slightly high valuation for the stock market.

However, the historical comparison is not the full story since the stock market is forward-looking. When compared to the forward 2017 operating earnings the P/E ratio drops to 16.0x. The reason for the more favorable valuation is two-fold. First, corporate earnings are still growing and are expected to march higher in 2017. Secondly, Republicans have promised to reduce the corporate tax rate from 35% to 15%, dramatically increasing profits available to shareholders. Analysts are just now beginning to reset their earnings expectations to include the change in the corporate tax rate, but according to economist Ed Yardeni at Yardeni Research, a change of this magnitude would increase 2017 S&P 500 earnings expectations to $142 per share. To put this number into perspective, an 18x P/E ratio would imply a valuation of approximately 2,550 on the S&P 500, a gain of over 12% from current levels.

At this point, it is important to point out that forward-looking earnings are just that, ‘forward-looking’. The future is impossible to predict. These types of earnings estimates are dependent upon the future turning out as expected, something that's not an exact science. As a starting point, the change to the corporate tax rate must pass Congress in a difficult political environment. Next, the economic recovery must continue without negative surprises. My goal is not to predict what the stock market will do in 2017, but rather to point out the reasons for the recent jump. The stock market is the culmination of the intelligence of millions of people and current market movement has already begun to price what could be.

Our current environment remains consistent with what we saw in 2016, and I would summarize it as a continued recovery. While we believe that the market is fully valued, trying to time the market by jumping in and out is incredibly dangerous. In 2016 many managers wrongly predicted a dismal year for the stock market and as a result, missed significant returns. We stayed focused on our long-term strategy, emphasizing the areas with the best valuation, and as a result, we were able to capitalize on a great year in the market. Similarly, we remain cautiously optimistic about 2017, but more importantly, committed to our long-term strategy for our clients.


Yardeni, Ed, "Stock Market Briefing S&P 500/400/600 Weekly Forward Earnings and Valuation." Yardeni Research. 2017.

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