I’m a technical person at heart. Part of my core is being a software developer. I’m always looking for the optimal plan. Whether it’s paying the least for good “stuff” or calculating the optimal traffic pattern to get where I want to go — I’m always in a mode of continuous improvement and optimization. It reminds me of being in my computer science data structures class in college, and reviewing all the various algorithms applicable for a given problem set.
Investing in the Stock Market
When it comes to the stock market, you hear about a lot of ways to determine whether the market is cheap or expensive. Many of the approaches start with a price-to-earnings ratio for, say, the S&P 500 index. This ratio helps one figure out how much they are willing to pay for a certain amount of earnings. You can look at trailing P/E ratios, which means price-to-earnings during the previous 12 months. Or, you can look at forward P/E ratios, which forecast and estimate the future 12 months of earnings based on guidance from the companies.
I think this is a good, but insufficient, approach to evaluate whether a market is cheap or expensive. If I were to come up with a metric to evaluate value, I would factor in interest rates and inflation, because both affect the price of various asset classes. Both interest rates and inflation affect so many aspects of the economy as a whole, and the investment in it.
Want to know whether the market is cheap or expensive?
S&P Forward P/E Ratio + Forward Inflation + Fed Short-term Rates < 25
This formula takes into account everything that is happening in the economy and in the market as a whole. We want to use the “forward” estimates for price-to-earnings and inflation because we are looking for a prediction of future behavior. We also want to consider the cost of borrowing at the most basic level, which is the Federal Reserve’s target for short-term interest rates. This number sets the tone for all other borrowing and all the fixed income markets.
We hear a lot about what the average P/E Ratio is for the stock market and that it is typically 15. We hear inflation is typically 2% — 3% and we hear short-term rates are typically 2%-3%. That would get us to a 21 on our formula — 15 + 2.5+ 2.5 < 25 is TRUE. You can back test several different scenarios to see when the market may have been expensive or cheap. This would have helped you in 1980, 2000 and 2008.
So, is the market cheap or expensive today? Here’s what I see:
S&P500 P/E Ratio + Expected Inflation + Fed Short-term Rates < 25
Therefore, the market is cheap or fairly priced today. If inflation increases dramatically, the price we pay for earnings of the S&P 500 (P/E Ratio) increases or the Federal Reserve starts hiking short-term interest rates, then that will affect our calculation.
So today, based on low inflation and low interest rates, I calculate the market is cheap, or fairly priced. I think you can continue to invest using the stock market. Once the formula indicates a <25 calculation, is when I will have concern and will consider paring back and eliminating my investments in stocks.
Disclaimer — The above references an opinion and is for information purposes only. It is not intended to be investment advice.