How to Invest in A Fully Valued Market

Yesterday, I posed the question “Why won’t this market go up in the face of good news?” As I said then, it is in large part because all the conceivable good news has been priced in, making the market “fully valued.” But what does that really mean? It means that average P/E ratios are about as high as, or maybe higher than they logically should be, but that in itself needs some explanation for most people.

The relative value of stocks is usually measured by the Price to Earnings, or P/E ratio. That is a number arrived at by dividing a company’s share price by the earnings made per share (EPS). So, for example, if XYZ is trading at $20 and has made $1 per share over the last four reported quarters, it would be said to have a P/E of 20. The stock is priced at 20x the earnings.

To get an overall view of the value of stocks, most analysts look at the average P/E of an index such as the S&P 500. To get that, you simply add up the P/Es of all 500 individual stocks that comprise the index, then divide by 500. That average P/E allows us to compare the valuation of stocks to other times in the past, and if we look at where that is now, it is easy to see why stocks are having such a hard time reacting positively to even good news on the vaccine front.

If we go back as far as we can, to the 1870s, the average P/E ratio for the S&P 500 is 16.8. It is currently just over 41.

Before that number makes you rush out and sell everything, there is an important point to be made here. As I’m sure you are aware, we are in exceptional times, so historical averages only tell us so much. Trailing P/Es, which is what we are talking about here, are based on profits over the last twelve months, and right now, that includes two quarters when the U.S. economy shut down in an unprecedented, but presumably temporary way.

Still, it is an old traders’ adage that everything eventually returns to the mean, so at some point, something has to give. For the average P/E of the S&P 500 to fall back towards its historical average, either stock prices have to fall, or earnings have to increase. Given that we are coming off such a major disruption, a bounce back in earnings looks almost inevitable so maybe these crazy P/Es aren’t that crazy after all.

The problem, however, is that that recovery hasn’t fully happened yet, but stocks are priced as if it has. In a fully valued market such as that, buying opportunities can be hard to find. Stock prices are already based on a return to normal, so unless the economy comes out of this a lot stronger than it was before, there is very little upside to most stocks.

One answer is often to look for stocks that are for some reason suffering declines that could be short-lived as the result of some changes. An example of that would be Salesforce (CRM).

Their recently announced acquisition of Slack (WORK) has not gone down well with traders, and CRM is over 20% below its high three months ago. The assumption seems to be that they overpaid for WORK, but if you believe, as I do, that there will be significant long-term synergies and benefits to that deal, the drop will prove to be temporary. That gives some upside to CRM, even if the market as a whole just waits for earnings to catch up with pricing.

Contrarian trading like this is risky so it is not for everyone, nor should you throw everything you have at a trade like this. However, in a fully valued market, just buying an index tracker or mutual fund can only take you so far. If you are prepared to take on some risk, buying things like CRM that are down on news is one way to give yourself a chance of some appreciation as the averages average out.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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