2021 Q3 Market Commentary: P/E Compression

Oct 14, 2021 | Market Updates

Period ending September 30, 2021

An Expensive Market?

On the surface, the U.S. stock market seems expensive, but is it really? The price-to-earnings ratio (P/E ratio) is used to determine the relative value of stocks and is calculated by taking a company’s stock price per share and dividing it by its earnings per share. The five-year average P/E ratio of the stocks in the S&P 500 Index is 18.8 while the current year P/E ratio is 21, which is why it may appear that the market is overvalued. However, it is normal to see elevated P/E ratios during different stages of the market cycle. In fact, during an economic recovery the current P/E ratio has historically been higher than the index’s five-year average. As the US economy transitions fully into a mid-cycle expansion, we believe strong corporate earnings will bring P/E ratios back to the index’s five-year average. We believe stock prices will increase but at a slower rate than corporate earnings; therefore, the stock market still has more room for growth. More on this later.

Looking Back at the Third Quarter

In the third quarter of 2021 the S&P 500 Index rose 1.82%, the MSCI Ex-US Index fell -1.84%, and the Barclay’s Aggregate Bond Index held steady with a return of 0.11%. While the annual inflation rate is at 5.3% for the 12 months ending August 2021, it was slightly lower than the previous 5.4% reading, and Fed Chairman Jerome Powell recently said that much of the upward pressure on prices is the result of supply-chain disruptions resulting from the COVID-19 pandemic. Powell commented that “inflation is expected to drop back to our long-term goal” (of 2%). We are still dealing with COVID-19 as the Delta variant went from 25% of COVID-19 cases at the beginning of the second quarter in the United States to 99% of all cases by the end of the third quarter.

As if high inflation readings and elevated COVID-19 case were not enough, perhaps the biggest economic news from the past quarter surrounded the Chinese real estate conglomerate Evergrande’s possible bankruptcy as it struggles to pay back its $300 billion in debt. Questions remain whether the Chinese government will bail out the company, and what a bankruptcy might mean for the world’s second largest economy and the global economy.

US Conditions Are Mostly Positive

When we look at the US economy going into the fourth quarter, the conditions are mostly positive.

  • Is the market relatively expensive? Yes. The S&P 500 P/E ratio is historically high, but as mentioned earlier, we still see opportunities for growth as corporate earnings continue to impress with an expected year-over-year increase for 2021 of 42.9% and 9.3% in 2022.
  • Is the government helping or hurting the market? Helping. Even if the Biden Administration’s proposed $1 trillion infrastructure and $3.5 trillion social spending bills do not pass, we anticipate a watered-down version will make it through Congress and add stimulus to the economy, which will be more money than the government spends in a typical year.
  • Is the Federal Reserve (the Fed) helping or hurting? Helping. The Fed bought $1.6 trillion of bonds this year, and even with the discussions of reducing quantitative easing and hikes in interest rates, this is unlikely to happen until 2022.

As you can see, several significant conditions are positive. Let us revisit the one negative condition that we mentioned at the beginning of this commentary: Historically high P/E ratios.

P/E Compression

We expect P/E compression will occur from slower growth in the price of stocks (P) with relatively strong earnings growth (E). Earnings growth this quarter is expected to be 14-15% when the historical average is 3.5%. Looking at the chart below, it appears that P/E compression has already begun.

GreenUp’s Outlook

When looking at the United States, it is hard to be negative about stocks. International markets remain a concern because nobody knows the systemic risk that China poses to the global economy. Furthermore, nobody knows what the Chinese communist party has in store for Evergrande and other corporations that are part of its highly controlled market. In this environment, we continue to be risk plus, although we are reducing our risk budget from 108% to 105% of our benchmarks. While GreenUp anticipates increased volatility in the U.S. and international stock markets, we do not see a systemic risk at this time. We are watching carefully for negative signs of liquidity issues and will reduce risk exposure if needed. As always, we continue to look for opportunities to add additional growth potential to the portfolios, while maintaining an appropriate level of risk as dictated by GreenUp’s investment benchmarks.

Summary

  • While U.S. stock market prices are high, corporate earnings are strong. We expect the market to continue to increase in value due to a mostly positive economic environment, yet at a slower pace and with more volatility.
  • Issues with the Chinese economy may negatively affect the global economy.
  • We are closely monitoring the situation in China and will reduce risk if needed.

GreenUp Investment Models Update

Active Allocation Models (Capital Appreciation, Growth, Balanced, Capital Preservation) 

Because of the uncertainty with China, we began reducing our Chinese market exposure last quarter and are replacing the Fidelity Emerging Asia fund (FSEAX) with the iShares Emerging Market ETF (IEMG). We are also moving a portion of the mid-cap growth allocation to mid-cap blend and reducing our allocation to the Yacktman Focused Fund (YAFFX).

Breakaway Stock Model 

We are replacing Nucor Corp (NUE), Cleveland-Cliffs Inc. (CLF), Hubspot Inc. (HUBS), and Albemarie Corp (ALB) with Atlassian Corp. (TEAM0, NVIDIA Corp (NVDA), Datadog Inc. (DDOG), and Devon Energy Corp. (DVN).

Equity Income Model 

No changes.

Large Cap Stock Model 

We are taking a slightly more value-based approach, selling Booking Holdings Inc. (BKNG), Lowes (LOW), and Charles Schwab Corp. (SCHW), and buying AmerisourceBergen Corp. (ABC), McKesson Corp. (MCK), Walt Disney (DIS), Philip Morris International (PM), and Anthem Inc. (ANTM).

Passive Allocation Models 

We are making slight adjustments to the overall asset allocation.

Tactical Equity Model 

We are selling iShares S&P Smallcap 600 Value Index ETF (IJS), iShares S&P Smallcap 600 Growth Index ETF (IJT), iShares Russell 200 ETF (IWM), iShares US Basic Materials ETF (IYM), and iShares S&P Midcap 400 ETF (MDY). We are adding iShares S&P 500 Growth ETF (IVW), Invesco QQQ Trust (QQQ), and the SPDR S&P 500 ETF (SPY).

Tactical Income Model 

No changes this quarter.

GreenUp Wealth Management is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

Author

  • Daniel Greulich, CFA, CFP®

    Chief Investment Officer | Wealth Advisor | Ann Arbor, MI -- Daniel leads our Investment Committee and partners with Aaron Kirsch, Chief Client Advocacy Officer to design and implement client portfolios with your advisor. Daniel brings 14 years of practical experience as a trader, financial advisor, and money manager at both large and mid-sized financial services companies to GreenUp Wealth Management. In addition, he holds a CFP® designation and is also a CFA charterholder. This combination of experience and knowledge helps Dan confidently guide his clients through the development, execution and monitoring of their customized financial plans.

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