There’s a lot of useful news and analysis out there for investors, but a lot of what you’ll find usually isn’t as informative as good hard data. When you find multiple bits of data that, taken together, tell a clear story about what’s going on in the stock market today, you can get an important edge that might help your portfolio.
Today we are going to take a closer look at three charts showing data that, when combined, tell an important and potentially mind-blowing financial story. If you invest, you should consider using this information to plan for what’s coming up in the market and better manage your portfolio for the long term.
1. The S&P 500 Shiller P/E ratio
The price-to-earnings ratio is a popular metric used by investors when analyzing a stock because it evaluates a stock based on its price in comparison to its earnings for the past year. If a stock’s P/E ratio is too high relative to peers, it might indicate the stock is over-priced and investors might want to wait for a price correction before buying in.
Some analysts apply the P/E ratio to market indexes. The Shiller S&P 500 P/E Ratio, for instance, can give us an idea of how expensive stocks are in general. What’s unique about this ratio is that instead of dividing by the earnings of one year, this ratio divides the price of the S&P 500 index by the average inflation-adjusted earnings of the previous 10 years. When this ratio gets too high, it often corresponds with the end of a bull market (i.e. a market correction).
Right now, this ratio, also known as the cyclically adjusted price-to-earnings (CAPE) ratio, is at its highest level since the 2000 dot-com bubble. That data point absolutely warrants further research and it’s something investors would be wise to monitor. It’s not necessarily a reason to panic, though, because there’s no slam-dunk proof that we’re on the verge of a market crash.
There are a few reasons the CAPE ratio is so high right now. Investors became very bullish following the COVID-19 market correction. Equities have had an excellent 18-month run since then, led by growth stocks. Rising valuations have been supported by economic recovery, government stimulus, and low interest rates (more on that later).
High-growth companies also make up more of the S&P 500 index than ever before. The seven largest stocks in this index are all in the tech sector, and they make up more than 25% of the total index weight. These companies have higher growth potential than mature giants from other sectors, which usually leads to higher valuation ratios. This naturally inflates the CAPE.
2. The S&P 500 dividend yield
A healthy dividend yield is essential for income investors and retirees. Looking at average yield across full indexes allows us to assess the opportunities available. If yields are too low, then investors might have to adjust their cash flow expectations
The average dividend yield for the S&P 500 generally moves in the opposite direction of the P/E ratio. Over the past year, stocks have grown more expensive, but dividends haven’t kept up. In this particular case, the drop has been fairly extreme, pushing the average yield for the index to its lowest point in nearly 20 years.
This chart has some important parallels to the price-to-earnings chart. It provides further evidence that the stellar market returns of late have been fueled by extra speculation, rather than fundamentals. The promise of economic recovery and accelerated growth related to the pandemic is likely playing a role here, but investors are undeniably pricing in more optimism and paying a premium.
Average dividend yield is also impacted by the shift in sector weighting of the index. As high-growth tech stocks (many of which don’t pay dividends) make up a larger percentage of the index, dividend stocks have a shrinking weighting. This naturally pulls the average yield down.
Nonetheless, many of the largest Dividend Aristocrats have lower-than-average yields right now. This is heavily influenced by other macroeconomic factors, and it might be a while until yields move back toward historical averages. Investors need to understand this dynamic and plan accordingly, especially retirees and income investors.
3. Corporate bond yields
Capital-market cash flows and asset valuation are complicated, but there’s a great chart that explains some of what’s happening in the charts above. Interest rates are near historical lows because of major monetary stimulus over the past 15 years. The Federal Reserve has responded to economic threats by bringing interest rates lower. That has moved bond prices lower as well.
The chart below shows the average effective interest rate for corporate bonds issued by the most creditworthy companies. But why include a bond chart in a discussion of the stock market? Well, because these current bond yields are exceptionally low, they tend to have an outsized effect on other parts of the economy, especially the stock market.
The Fed’s expansionary monetary policy has three related impacts that boost stock prices:
- Low interest rates stimulate growth by providing businesses with cheap access to capital. This encourages spending on marketing, product development, new hires, and physical capital. Investors like policies that support growth.
- Low bond yields also encourage investors to sink more capital into the stock market. Debt securities don’t provide the same returns at lower interest rates, so riskier investments don’t have as much opportunity cost. This also makes dividend stocks more appealing as income assets.
- Low interest rates tend to create more inflation. Business revenue and profits both tend to rise along with prices in the economy, and so do stock prices. These make equities a good hedge for inflation, driving stocks higher.
Putting all the pieces together
These three charts together provide some basis for everything going on in the stock market today. The market has charged to all-time highs due to interest rates, inflation, and recovery expectations. Business fundamentals are just fine right now, but they aren’t enough to explain the stock market growth we’ve seen in the past 18 months. As the Fed starts to taper and eventually raise rates, it’s likely to cause some volatility in the stock market.
We might not see a crash, especially if corporate earnings continue to impress as much as they did in the first half of the year. However, we might be looking at some volatility in the market near term. Don’t be caught off guard, and don’t overreact when volatility predictably hits.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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