The stock market today is expensive. Investors are paying as much as $45 for each dollar of corporate earnings, according to the trailing 12-month price-earnings ratio — commonly called p-e ratio — for the S&P 500. By contrast, throughout history, the S&P 500 p-e ratio has averaged just under 16 — or $16 dollars invested for every $1 in corporate earnings.
Will the trend continue into 2021? One can only hope 2020 was an anomaly and not the new norm. Early indicators suggest the forward p-e ratio, which looks at expected earnings over the next 12 months as opposed to the previous 12 months, has fallen into the low 20s. But even this is an imperfect benchmark. It’s still high but less astronomical than trailing 12-month earnings would have investors believe.
Deron McCoy, chief investment officer at Signature Estate & Investment Advisors, or SEIA, proposes investors evaluate markets by applying “future forward earnings,” or earnings expectations further into the future when life should hopefully have returned to pre-pandemic norms.
We spoke with McCoy about why a future forward perspective may be the best one, and what taking such a stance could mean for investment opportunities. Here are edited excerpts from the interview.
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You wrote an article for SEIA about how the stock market may not be as expensive as it appears if we look at future forward price-earnings ratios. Can you share your reasoning?
Owning stocks is owning a claim on the future cash flows of the company. In the midst of a historic pandemic, current cash flows do not necessarily represent the true future opportunity of the company. We can think of this on a more personal level, as one should not measure their own net worth in the middle of a natural disaster or the immediate cleanup and recovery, but rather look to the future once things get back to normal.
[READ: Q&A: BlackRock’s Jeff Rosenberg on Systematic Fixed-Income Investing.]
What is the danger of basing investment decisions on future forward price-earnings?
The risk of basing investment decisions on future forward earnings is that those earnings are simply projections and are not fully guaranteed. But we feel it’s a risk worth taking as an investment with guarantees — for example, a certificate of deposit — is not attractive at this time, given the low-rate environment we’re in.
Making projections is difficult in normal times but especially so in our current setting. However, we can take some comfort in the fact that recent earnings projections have been too low. Corporations have been beating 2020 fourth-quarter estimates by a wide margin. Capitalism and corporations have been able to adapt and manage through the crisis, suggesting the lofty earnings projections and aspirations for 2022 may not be lofty enough.
[READ: Q&A: Schroders’ Head of Sustainability Talks ESG Investing.]
There is no denying that stocks are expensive, even in a future forward world. Where are you seeing the most value in today’s market?
Overseas and the value side of the ledger offer valuation discounts to large-cap and large-cap growth in particular. But we shouldn’t invest in value for value’s sake. Value needs a catalyst. So the argument for value is not just because it’s value; it’s because the sectors with tailwinds happen to reside in the value index. If you dig deeper, the main sectors in the value index have tremendous tailwinds heading into 2021 and beyond, so the catalysts are starting to line up.
The vaccine should help the global economy and global trade, benefiting overseas stocks. And not only will the vaccine help to reopen the broader local economy, it will allow us to reintroduce some fun back into our lives. Travel, leisure, restaurants and brick-and-mortar retail will all benefit. And these are industries that do not dominate the large-cap growth index. While we don’t see tech going away anytime soon, the work-from-home and school-from-home landscape will start to diminish. So the tailwinds for value are the same headwinds for growth.
The vision out of the nation’s capital should provide a softer tone on global trade — again benefiting overseas stocks. Stateside, additional stimulus should boost the broader economy, possibly igniting inflation. In an inflationary world, commodities and commodity stocks do well — namely energy and materials.
These industries need higher levels of capital expenditures and machinery to run their business, and this machinery typically comes from industrial-type companies. Think of a miner: They need trucks and machines from Caterpillar Inc. (ticker: CAT). Thus, industrials are poised to benefit from an inflationary world. And with higher inflation comes higher interest rates, which should benefit financials (as these companies’ profit margins expand with rising interest rates). The sectors that stand to benefit are energy, materials, industrials and financials. These are the big stalwarts of the value index.
How should advisors and investors be positioning their clients and themselves as this year progresses?
Investors love their tech stocks and we do, too. But we’re urging investors to use their profits to reallocate into more unloved areas of the market that stand to benefit from the shifting tailwinds stemming from the changes in the outlook of COVID-19 and the conversations happening in national politics.
What are you foreseeing in terms of the global economic and investment environment for 2021?
As the world digs itself out of this pandemic, we should continue to see the global economy improve.
A large amount of pent-up demand will drive investment activity for several quarters. But perhaps the biggest risk is whether the Federal Reserve blinks as interest rates continue to march higher. At present, this is not a near-term risk but one that we are mindful of in the back half of this year.
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Q&A: Why the Stock Market May Not Be as Overpriced as We Think originally appeared on usnews.com
