There is a lot of news and analysis that is useful for investors, but a lot of what you will find is usually not as informative as good hard data. When you find multiple pieces of data that taken together tells a clear story about what’s going on in the stock market today, you can gain a significant advantage that could help your portfolio.
Today we’re going to take a closer look at three charts showing data that, when combined, tells an important and potentially mind-boggling financial story. If you are investing, you should consider using this information to plan what is going on in the market and better manage your portfolio over the long term.
1. The P / E ratio of the S&P 500 Shiller
Price-to-earnings ratio is a popular measure used by investors when analyzing a stock because it values a stock based on its price against its earnings from the previous year. If a stock’s P / E ratio is too high relative to its peers, it may indicate that the stock is overvalued and investors may want to wait for a price correction before buying.
Some analysts apply the P / E ratio to stock indices. The Shiller S&P 500 The P / E ratio, for example, can give us an idea of the price of stocks in general. What’s unique about this ratio is that instead of dividing by one-year earnings, this ratio divides the price of the S&P 500 Index by the inflation-adjusted average earnings of the last year. 10 years. When this ratio gets too high, it often corresponds to the end of a bull market (i.e. a market correction).
Right now, this ratio, also known as the Cyclically Corrected Price / Earnings Ratio (CAPE), is at its highest level since the dot-com bubble of 2000. This data point absolutely warrants further research. and it is something that investors would be wise to watch out for. This is not necessarily a reason to panic, as there is no compelling evidence that we are on the verge of a stock market crash.
There are several reasons why the CAPE ratio is so high right now. Investors have become very optimistic following the COVID-19 market correction. Since then, stocks have had an excellent 18-month run, led by growth stocks. Upward valuations have been supported by the economic recovery, government stimulus measures and low interest rates (more on that later).
High growth companies are also making up the S&P 500 Index more than ever. The seven largest stocks in this index are all in the tech sector and account for more than 25% of the total weighting of the index. These companies have higher growth potential than mature giants in other sectors, which generally leads to higher valuation ratios. This naturally inflates the CAP.
2. The dividend yield of the S&P 500
A good dividend yield is essential for fixed income investors and retirees. Examining the average return on all indices allows us to assess the available opportunities. If yields are too low, investors may need to adjust their cash flow forecasts
The average dividend yield of the S&P 500 generally moves in the opposite direction of the P / E ratio. Over the past year, stocks have gotten more expensive, but dividends haven’t followed suit. In this particular case, the decline was quite extreme, pushing the average index return to its lowest level in almost 20 years.
This chart has important parallels with the price / earnings chart. It provides further evidence that stellar market returns of late have been fueled by further speculation, rather than fundamentals. The promise of economic recovery and accelerated growth linked to the pandemic is likely playing a role here, but investors are undeniably banking on more optimism and paying a premium.
The average dividend yield is also affected by the change in the 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 declining weighting. This naturally pulls the average yield down.
Nonetheless, many of the biggest dividend aristocrats currently have below-average returns. This is heavily influenced by other macroeconomic factors, and it may take some time for yields to approach historical averages. Investors need to understand this dynamic and plan accordingly, especially retirees and income investors.
3. Yields on corporate bonds
Capital market cash flow and asset valuation is complicated, but there is a great chart that explains some of what is happening in the charts above. Interest rates are near all-time lows due to significant monetary stimulus over the past 15 years. The Federal Reserve responded to economic threats by lowering interest rates. It also pushed down bond prices.
The graph below shows the average effective interest rate on 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 unusually low, they tend to have a disproportionate 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 invest more capital in the stock market. Debt securities don’t provide the same returns at lower interest rates, so riskier investments don’t have as many opportunity costs. It also makes dividend-paying stocks more attractive as income assets.
- Low interest rates tend to create more inflation. Both corporate income and profits tend to increase with prices in the economy, as do stock prices. These make stocks a good hedge against inflation, pushing stocks up.
Assemble all the parts
These three charts together provide a basis for everything that is happening in the stock market today. The market has hit all-time highs due to interest rates, inflation and recovery expectations. Corporate fundamentals are great right now, but they’re not enough to explain the market growth we’ve seen over the past 18 months. As the Fed begins to cut and possibly raise rates, this will likely 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 expect some volatility in the market in the near term. Don’t get caught off guard and overreact when volatility hits predictably.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.