Going back to the fundamentals of investing and market valuations, let’s understand if the markets are currently overvalued or undervalued. In this report, let’s look at the price-to-earnings multiple which is a popular financial metric that helps investors analyse the overall valuations of the indexes.
After the recent correction seen in the global markets and the U.S. indexes, the 12-month forward P/E ratio of the index is seeing significant correction from its previous highs. This is largely led by the price corrections as an impact of the ongoing geopolitical tensions between Russia and Ukraine that saw indexes correct across geographies.
Indexes see corrections on its lofty valuations
According to historical data, the S&P 500 average P/E ratio for the last 40 years (1981-2020) is about 21.92. The highest price-to-earnings on the index was around 123.73, which was seen in May 2009 (after the market crash), and the lowest price-to-earnings was around 5.31 in December 1917. Markets are currently trading closer to the historical average P/E and lower than the highs of last year (price-to-earnings of 45.89 seen in July 2021).
Exhibit 1: S&P 500 index’s forward 12-month P/E ratio
Source: FactSet.com, February 2022
Sectors like Healthcare, Energy and Financials trade below the five-year average P/E ratios
At the sectoral level, materials, healthcare, financials, energy and communication services are all trading below the S&P 500 index’s five-year average P/E ratios (graph below). Meanwhile,communication services, healthcare and materials sectors are all trading below their five-year sectoral averages too. Value may be found in these lower price-to-earnings S&P 500 sectors.
Exhibit 2: S&P 500 index’s sectoral 12-month P/E Ratios
Source: FactSet.com, February 2022
Price declines on the S&P 500 index largely contributed to the lower forward P/E multiple
The S&P 500 index closed at a record high of 4,796 on January 3, 2022 with a forward 12-month P/E of 21.4 at that time and we have see a correction close to 12% from its January peak YTD 2022 and this price correction on the index has largely contributed to the decrease in the price-to-earnings multiple on the index.
Exhibit 3: S&P 500 index’s Forward 12 month EPS vs. 5-year average
Source: FactSet.com, February 2022
EPS estimates
Taking into consideration the earnings estimates (EPS) of the S&P 500 index from the chart below, the index is trading at 19.25 times the 2022 earnings, and 17.55 times the 2023 earnings estimates (lower than the historical average price-to-earnings ratio of 21.92 on the S&P 500 index), which explains why investors and large fund houses are looking at U.S. markets as an opportunity to invest for long-term at current market levels purely on market valuations.
Exhibit 4: Analysts’ estimates of S&P 500 earnings for 2022 & 2023 at the start of 2022
Source: Prof. Ashwath Damodaran’s S&P 500 Earnings Estimates, February 2022
Equity markets typically trade higher after the geopolitical events
When we look at some of the geopolitical events in the past, it’s worth noting that the equity markets have shown an ability to trade through some of these major events both in the near and the medium term. While there may not be an exact historic parallel for events that may likely transpire in Ukraine currently, the below table provides some useful perspective for investors to understand how the markets have traded in the months following the major geopolitical events.
Exhibit 5: Returns of the S&P 5000 index after a select geopolitical event in the past
Final thoughts
Overall corrections have been impactful for investors to look at U.S. markets in terms of valuations which makes it attractive at current levels based on the price-to-earnings multiple and are now trading closer to their historical averages. The recent corrections have made most analysts re-look their views which saw some cool off in the valuations. Although the valuations are down from the highs seen last year during the pandemic, and the beginning of 2022 analysts believe that the ongoing headwinds in terms of rising inflation, geopolitical tensions between Russia and Ukraine, rising crude oil prices and the Fed’s interest rate hikes coming in are all likely to impact the markets in the near-term.
On the S&P 500 index, the projected record-high EPS of $224 for CY2022 and $245 for CY2023 still remain and this increase in earnings is likely to bring down the P/E multiple even lower in the coming days.
