Is the Stock Market Expensive?

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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.

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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.

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The Formula

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.

Average

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.

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Today

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

18.76 + 1.4 + 1.25< 25 is TRUE; (click numbers to link to data)

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.

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Disclaimer — The above references an opinion and is for information purposes only. It is not intended to be investment advice.

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