There’s good news for investors who were scared off by high price-to-earnings (PE) ratios when stocks sat at record highs in January: Rising earnings and the latest pullback in stocks have brought valuations down near long-term averages. Based on consensus estimates for the next 12 months, the S&P 500 Index PE ratio fell from 18.5 on January 26 to 16.3 as of April 27. That’s a relatively big drop.
Even more reassuring for those concerned about valuations is that, despite their recent rise, interest rates and inflation remain low by historical standards. LPL Research Chief Investment Strategist John Lynch notes, “Stock market valuations are above average, but when factoring in interest rates and inflation that are below historical averages, we think valuations are actually quite reasonable.”
If we break PE ratios down by interest rate levels (based on trailing earnings so we can get a longer history), our LPL Chart of the Day shows that a 10-year Treasury yield near 3% is consistent with above-average S&P 500 PE ratios:
Similarly, the current pace of annual changes in the Consumer Price Index, at 2.4%, supports higher valuations:
Bottom line, we believe slightly above-average stock valuations are justified based on the strong earnings outlook, still-low interest rates, and low inflation. Combining reasonable valuations with solid fundamentals and a positive technical and sentiment backdrop, with the S&P 500 about 7% off of its January highs, we think stocks look good here. We maintain our S&P 500 year-end 2018 fair value target of 2950–3000, implying double-digit stock market returns from current levels.*
*We believe 2018 earnings will be supported by stronger global economic growth, a pickup in business spending, strong manufacturing activity in the United States, and the new tax law. Our year-end S&P 500 fair value target range is 2950–3000 based on a price-to-earnings ratio (PE) of 19.5.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
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