Over the last several weeks we have seen a sharp drop in the stock market. Is this a simple correction or something more? Or could there be something else going on? It is hard to turn on the financial news for an hour or so and not hear several different opinions about the valuations of the stock market. While some argue that the market is expensive, quite a few others are banging the table saying how cheap it is. So which is it? While the consensus S&P 500 Earnings estimate is around $123, which would imply a Price to Earnings ratio (P/E) of about 15.5x at today’s prices. That is hardly “Cheap” but certainly not expensive either.
With that said, a little analysis can go a long way. Let’s take a look at the top ten S&P 500 stocks which is an index weighted by market cap:
Company Price 2016 EEPS 2016 P/E Ratio
Apple $100 $9.48 10.5x
Microsoft $52 $2.76 18.9x
Exxon $76 $3.84 19.8x
J&J $100 $6.18 16.2x
Gen. Electric $28 $1.50 18.9x
Berk. Hathaway $126 $9.40 13.4x
Amazon $598 $5.54 107.9x
Wells Fargo $48 $4.30 11.2x
Facebook $97 $2.88 33.8x
Google $713 $34.21 20.9x
The average P/E for the top ten stocks is 27.2 – much higher than the historical average for the entire index of around 16.0x. With these 10 stocks making up about 17.6% of the weighting, that means the other 490 stocks have to have an average P/E of 13.0 to match the current P/E expectation of 15.5x. So, perhaps both arguments are correct. Perhaps some parts of the market are expensive while other parts look wildly cheap? Perhaps there needs to be a rotation whereby money flows from the expensive growth stocks and into the cheap value stocks. We saw this happen in the early part of this century at a time when the Dot Coms were flying high leaving behind your traditional value stocks. Time will tell but it is something to keep an eye on in the coming weeks. It is quite possible to have a flat or even down market as many stocks do well while others retreat. In fact, just the opposite happened in 2015 while the so called “FANG” stocks (Facebook, Amazon, Netflix and Google) gained handsomely and propped the market weighted average up (3 of the 4 are in the top 10) while most everything else fell. A rotation might be just what this market needs.
Chesapeake Financial Advisors is a fee-only financial planning, investment advisory and tax planning firm with offices in Towson, Bel Air and Columbia, Maryland.