What happened the last time the S&P 500's forward P/E was this high

A version of this article first appeared on TKer.co

It’s not hard to argue that stock market valuations are high.

According to FactSet, the forward price-earnings (P/E) multiple for the S&P 500 is 22.9x, which is significantly above its 10-year average of 18.6x.

So, what are we supposed to do with this information?

Some people may be inclined to dial back their exposure to stocks under the assumption that prices are due for a correction. Some might sell everything. Some might even short the market.

The problem is that valuation ratios alone aren’t particularly reliable predictors of where prices are headed. Forward P/Es tell you almost nothing about what prices will do over the next 12 months. P/E ratios seem to provide a stronger signal on long-term returns, but the signal is far from perfect.

We don’t have to go back too far to see another instance when the forward P/E was this high. In 2020, this metric surged as stock prices rebounded from their pandemic lows, topping out at 23.6x in August of that year.

The S&P 500 was trading at around 3,500 back then. And as always, there was a healthy mix of optimism and skepticism.

Today, the index is near 6,900.

That’s right. The S&P just about doubled in five years.

And if you’re keeping track of the math, the reason why stock prices doubled as the P/E ratio was relatively unchanged is because earnings also doubled during the period, bolstered by stubbornly high profit margins.

To be clear, this wasn’t smooth sailing. We had a bear market in 2022 and a 19% rout at the beginning of this year.

If you successfully sold the highs and bought the lows during that period, then I’m happy for you.

But most of us are terrible at timing the market in such a way that yields a return that’s better than simply holding or dollar-cost-averaging during the period.

Maybe we’re due for a correction that sees stock prices falling sharply lower, which would cause P/E multiples to move closer to their historical averages.

Or maybe valuations remain stretched.

Or maybe we get an outcome where prices climb and valuations come down.

“P/E multiples can compress from prices falling but also from earnings rising,” BofA’s Savita Subramanian wrote earlier this month.

That’s right. If earnings are heading higher, P/E multiples can actually come down as long as prices are rising at a slower rate.

The critical variable we keep falling back on is earnings, which makes sense when you remember they’re the most important long-term driver of stock prices.

And fortunately for investors, earnings are expected to grow at a double-digit rate through at least 2027.