A client recently asked me “the FTSE is over 9,000?! What’s that all about?”.
He’s been investing for nearly half a century – so it was probably valued around 1,000 when he first started – and in contrast I can appreciate why 9,000 seems expensive…
But I told him that it’s actually quite reasonable!
Stock prices alone are meaningless
You see a company (or a whole stock market) is simply worth a multiple of corporate profits (earnings).
It’s that multiple – price divided by earnings – that determines whether stocks are cheap or expensive.
At a given price, are we paying 5x earnings for a company, or 25x earnings?
That’s how you identify richness or cheapness of a stock, the price on its own is meaningless.
Let’s look at two examples…
The MSCI UK and MSCI USA are both stock market indexes, which measure the price of a basket of companies.
There’s about 73 companies in the MSCI UK, and 547 in the MSCI US.
The MSCI UK Index is valued at 386.68. And the MSCI US Index is valued at 605.56…
…but as we already know the price on it’s own is irrelevant.
When we consider the price relative to earnings, we can see the bigger picture.
US Stocks appear to be close to the most expensive levels they’ve been since the tech bubble in 2000 – perhaps a reason for caution.
Whilst in the UK, stocks appear to be slightly below their long-term average, but broadly inline with valuations over the last 20 years.
… a much more compelling investment, considering only current valuations.
But again there’s more to the picture.
Earnings growth is important too
You see if a company is worth a multiple of it’s profits, then the rate at which those profits grow should influence how much we’re willing to pay.
Markets (or companies) which grow earnings faster, will increase in value faster, so can justify higher prices today.
The opposite is true of slow growing markets.
In the MSCI UK earnings per share, have been relative static for over a decade. They’ve been volatile, but haven’t meaningfully increased.
Meanwhile in the US earnings have been steadily climbing for 3 decades. Which justifies a higher price than the UK, provided earnings growth continues.
This is part of the reason why, over the last 30 years, the average P/E ratio for the US has been higher than the UK. It’s been baked into valuations (and expectations) for some time.
However, the growth in stock market prices in the US, has certainly outstripped the growth in US earnings – otherwise it’s P/E ratio would remain the same.
Should the US stock market receive a higher valuation ration than the UK?
By some amount, yes.
But is the US stock market good value right now?
Probably not.
And are all stocks expensive?
Certainly not.
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