Numbers don't lie...but they also don't tell the whole story.
Recently I was reminded of the phrase, "Beauty is in the eye of the beholder." That could apply to how the equity markets are valued as well. Many think markets are overvalued; some say we're undervalued. Which is right? What do the numbers say?
Start with the Top Line & Bottom Line
Every business has a top line (sales), and a bottom line (earnings). Two common ratio comparisons are based around these.
- Price-to-Sales = How much would you pay for every dollar in revenues a business makes? Let's temporarily remove profitability from the equation. If we took the market value of all publicly-traded US securities ("price"), and we compare it to GDP ("sales"), using the most recently published data, we would get a ratio of about 196%. Several years ago, Warren Buffett was being interviewed, and discussed this methodology. He stated that "...if the ratio approaches 200%...you are playing with fire." If we took the market value of all publicly-traded US securities ("price"), and we compare it to GDP ("sales"), using the most recently published data, we would get a ratio of about 196%. Several years ago, Warren Buffett was being interviewed, and discussed this methodology. He stated that "...if the ratio approaches 200%...you are playing with fire."
- Price-to-Earnings = This is perhaps the most common metric investors are familiar with. For comparison, consider using the Rule of 20 as a rule of thumb (20-inflation=P/E). With inflation at 6.8%, the Rule of 20 P/E would be 13.2. However, with an earnings-per-share forward estimate of about $220, the current P/E ratio is closer to 21.1.
Potential Obstacles
- The most notable issue today is inflation, which has been caused by both the supply chain delivery issues as well as the previously mentioned government support. However, what seems to be ignored is the fact that wage growth isn't keeping up with inflation, causing negative real growth year-over-year. In other words, even if you got a raise, your expenses went up as much and even a little more!
- Unemployment (from the November 2021 report by the Bureau of Labor Statistics): "The unemployment rate fell...to 4.2% in November. The number of unemployed persons fell...to 6.9 million. Both measures are down considerably from their highs at the end of the the February-April 2020 recession. However, they remain above their levels prior to the coronavirus (COVID-19) pandemic (3.5% and 5.7 million respectively, in February 2020).
Reasons to be Optimistic
It's not all doom and gloom - not by a longshot. Resolving the supply chain would go a long way not only in helping to contain inflation, but also in allowing companies to keep hiring to fulfill consumer demand that has been surging for a year (which could also lead to greater consumer spending). Until then, earnings estimates should continue to rise because of the reduced expenses I mentioned earlier. Also, with the Federal Reserve signaling that they will raise rates and taper their support (i.e., stop putting additional money into the economy by buying bonds) sooner than initially anticipated, bonds will be less attractive since prices move inversely to rates. Risk management will be important, but opportunities may present themselves if there is some short-term volatility.
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