Research Department

U.S. P/Es: Expensive, but far—very far—from bubble territory

March 11, 2015 - 0 comments

In a recent video, Bill McNabb (CEO) and Tim Buckley (Chief Investment Officer) of the Vanguard Group made a rare commentary about U.S stock price-to-earnings (P/E) multiples.

What they said

Since the end of the financial crisis, the U.S. stock market has had one of the greatest bull runs in its history. Over the last six years, it returned about 250%, including dividends. However, this appreciation must be kept in perspective: the starting point of that positive run was the bottom of a deep downturn, so much of it was recovering the ground lost in 2007-2008.

McNabb and Buckley recognize that U.S. stocks are currently trading at P/E multiples that are higher than their historical average. Since “valuation is the key to future returns,” they conclude that equity returns will likely be lower in the coming ten years. They also specify that while U.S. stocks are expensive, they are far from being in extreme “bubble” territory.

My view

I agree that U.S. stocks are moderately expensive. At 26 times the earnings, they are far from the lofty levels (40 times and above) reached at the peak of the tech stock bubble in 2000. I also agree that expected returns move inversely with P/E ratios. But I would warn against any temptation to bail out of U.S. stocks on that basis. P/Es predict about 40% of stock market fluctuations, leaving the other 60% to random variations. Thus, P/E ratios have next to no predictive power over horizons shorter than ten to twenty years. The idea of selling stock now in the hopes of buying it back in a few months at a lower price is ill-advised.

McNabb and Buckley are not the only market experts who have mentioned the expensiveness of the U.S. market: it’s been in the press very frequently in recent months. Most of these articles fail to mention, though, that other markets are trading at much lower P/E multiples, as displayed in the table below.

Investment conclusion

This discussion about P/Es bolsters the case for portfolio diversification. The U.S. represents half of the global equity market, but, it is only one of forty-five investable national markets. By investing not only in U.S. stocks but also in Canadian, international developed and emerging markets, the risk of being concentrated in an expensive, low-expected-return market is reduced to a minimum. With global diversification, your portfolio can benefit from a reasonable expected return without having to predict the future or having to trade in and out of the market. 

By: Raymond Kerzérho with 0 comments.
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