Are Stocks Priced for Perfection or Recession?

We often get asked about stock market valuations. Specifically, investors want to know if stocks are priced for perfection or for a recession. If “perfection” is defined by the 2000s peak, then fortunately, stocks are nowhere near that overvalued, based on the price-to-earnings ratio. But, if we take a more refined look at historical stock market valuations at peaks and lows, we find some cause for concern.

Global stocks currently trade at a price-to-earnings ratio that has marked cyclical peaks in the stock market in the past. The trailing price-to-earnings ratio (the price divided by the last 12 months of earnings) is in line with where it has been at prior cyclical peaks in the stock market over the past 50 years, on average.

Stock market valuation at cycle peaks and troughs

Source: Charles Schwab, MSCI and Factset data as of 10/11/2019.

The MSCI World Index begins at the end of 1969 and includes six recessions (counting the double-dip in 1980 and 1981-82 as one long recession) offering six cycle lows and five cycle highs over 50 years. The average price-to-earnings ratio at the peaks was 19.7 and 13.0 at the lows. Refining this slightly by eliminating the outlier high (in 2000/2002) and low (in 1973/74) we get an average of 18.5 and 11.6, where markets have more consistently been valued at turning points.

This makes the current price-to-earnings ratio of 18.6 in line with the average of these past peaks and much nearer to being priced for perfection, rather than recession. In fact, the current stock market valuation is 40% above the average price-to-earnings ratio at prior market cycle lows.

We can break down the world index into the U.S. and international components to see how price-to-earnings ratios compare to their past peaks and troughs. Unsurprisingly, given U.S. outperformance of the past 10 years, U.S. stocks feature price-to-earnings ratios higher in their historical range than do international or emerging market stocks. But none of these asset classes appear to be priced for recession.

Historical ranges and current price-to-earnings ratios by global asset class

U.S. based on S&P 500 Index, Int’l based on MSCI EAFE Index, and EM based on MSCI Emerging Market Index.
Period includes 1969 to present for U.S. and International. EM history goes back 25 years to 1995.
“Recession Average” refers to the average price-to-earnings ratio at cycle lows and “Perfection Average” refers to the average ratio at cycle highs.

Source: Charles Schwab, MSCI and Factset data as of 10/11/2019.Why use the last 12 months earnings instead of the forecast for the next 12 months for this analysis? The main reason is that we need to look at a long history. The history of analysts’ consensus earnings forecasts do not go back much more than 20 years for most markets where the 1,650 companies in the MSCI World index are headquartered. Limiting our analysis to this time frame would allow us to study only two or three market cycles. Using historical earnings data we can look back at the full history of six cycles and 50 years for analysis.

Despite the more limited data set, we can also take a look back across countries using price-to-earnings ratios based on the analysts’ consensus estimates for the next 12 months earnings per share for the companies in the indexes. The table below shows that most of the selected countries in Europe have forward price-to-earnings ratios that are near the middle or low end of the range of where they were at the market peaks and lows of the past 20 years, while those in the Americas and Asia are mixed, as you can see in the heat map below.

Valuation heat map

Forward price-to-earnings ratio measure using current price divided by the analyst consensus for the next twelve months earnings for companies in the MSCI index for the indicated country or region (ex. MSCI Europe Index, MSCI United Kingdom Index, etc).
Peak and low refers to the highest price-to-earnings ratio during past 20 years of the two global cyclical market peaks (March 2000 and October 2007) and lowest of the two cyclical lows (March 2003 and February 2009). Current is as of the end of September 2019.
Red indicates the peak price-to-earnings ratio, green indicates the low price-to-earnings ratio. Shading of the current ratio is based on where in the range it falls between the high and low.
Source: Charles Schwab, Factset data as of 10/11/2019.

Of these countries, Japan appears priced for recession while Australia seems priced for perfection with forward price-to-earnings ratios below prior cycle lows and above prior cyclical peaks, respectively.

In sum, examining price-to-earnings ratios offer some reasons for concern. But, in general, do not signal the heightened vulnerability of the 2000 peak. Yet, if earnings continue to slide, the market may find it difficult to support price-to-earnings ratios near the high end of their historical range. A broader U.S.-China trade deal and a smooth Brexit would be key ingredients to giving earnings growth a second wind, supporting a rise in stocks without relying on an unsustainable rise in price-to-earnings ratios.