Is the stock market overvalued? For a long time, the answer was a definite yes. After last year’s 18% decline, the S&P 500 is certainly more reasonably valued than it was, but still not cheap. The price/earnings or P/E ratio is commonly used to evaluate stock market valuation. This measures how much you pay (the price) relative to how much corporate profit you get (the earnings). The lower the price you pay, the cheaper the market.
The overall stock market currently trades at a P/E of 20.6. That’s down from the peak of 2021, but still pretty high compared to historic levels. When the stock market really gets clobbered, such as during the Global Financial Crisis, the P/E ratio has fallen into the teens. During the late 1970s and early 1980s, it was below 10. However, P/Es below 20 have been relatively rare over the past 30 years or so. No one knows why, but a change in capital gains tax rates, greater familiarity and comfort with the stock market, or a higher overall liquidity level as the debt-to-GDP ratio has risen, are possible culprits.
In any event, today’s stock market doesn’t look particularly attractive, especially if you think the economy will slow, corporate earnings will get cut (which will drive the P/E higher the hard way), or a financial crisis may unfold. That has left a lot of investors on the sidelines.
However, the overall stock market is not representative of all stocks within the market. There are pockets, quite a few pockets actually, where valuations appear very attractive.
Value stocks have been beaten up over the past decade or so as growth-oriented technology stocks have dominated the market. That is similar to what happened in the Dot Com Boom of the 1990s. However, those periods don’t persist forever, and when the reversals come, they can be powerful. The P/E for large-cap value stock is less than 10. For small-cap value stocks it is even cheaper, at 8.1. No matter how you look at it, those are compelling levels. At some point, and it may already be happening, investors will recognize the opportunity presented by such cheap stocks, and the value sector will rise.
A similar dynamic is happening with international stocks. They are generally unloved at the moment because they too have underperformed the overall US stock market for many years. However, with a P/E ratio of 13.4 for developed international stocks and only 11.1 for emerging market stocks, it would not be surprising to see overseas stocks outperform the US in the coming decade. Combining value and international is even more compelling with developed world value stocks trading at a P/E of 8.3 and emerging market value stocks sport a P/E of only 7.1. Even if earnings get cut in half and these P/Es double, the stocks will still appear quite reasonably priced.
If the overall stock market falls from here, which we consider fairly likely, value and international stocks will probably also decline. However, their low valuations should help insulate them from severe declines, and we expect that they will outperform growth-oriented stocks. So, today may not be the day they ring the bell to signal the market bottom, but for certain market sectors, this will likely be an attractive buying opportunity when we look back from a decade in the future.
Watch the related ACM InvestED Vidcast: Stock Market Valuations – Why they (still) matter