What The Forward P/E Ratio Can Tell Us About Stock Market Risk Today

What The Forward P/E Ratio Can Tell Us About Stock Market Risk Today

The Price to Earnings (P/E) ratio is a great tool to contextualize overarching trends in the stock market—including current strength, expected strength (or weakness), and vulnerability to shock.

The P/E ratio is found in many forms.  Trailing, Forward, Cyclically Adjusted, Discounted, Operating, Actual. They all move over time and the value of each requires an understanding of the calculation methodology.  The key to proper analysis is to focus on one measurement over time.  For today, we will focus on the S&P 500 price relative to the 12 month forward projected operating earnings.

Components Of The Forward P/E Ratio

The components are relatively straight forward.  The price is the price.  Earnings are the consensus expectations for operating earnings over the next 12 months.  The nuance to understand is that forward earnings expectations are changing. 

Every week the consensus expectations for total index earnings are updated as analysts and companies sharpen their forecast pencils—company by company.  The important thing to remember is that the 12-month window is always moving forward, three months at a time.  Therefore, the denominator of the forward P/E ratio is updated over time to always incorporate the next 12 months.  We roll the window forward early in each quarter which assumes that estimates for the current quarter are generally accurate. 

For example, in early April, our “12-month forward earnings” incorporates expectations for the period July 1 through the next June 30.  It is rolled forward in this manner every quarter.  Corporate earnings over the last 80 years have grown by about 6% per year.  This general trend of earnings growth is a constant depressant on the forward P/E ratio.  If stock prices are unchanged for a quarter and earnings growth follows the long-term trend, the forward P/E will drop by 1.5% every three months (maybe from 16 to 15.75).

Earnings and stock prices never follow a constant linear trend.  Earnings forecasts generally change gradually except for external surprises.  The pandemic is a great example as forward earnings forecasts dropped by 20% over a few months.

Stock prices tend to be more volatile than earnings.  Last week we saw historically extreme price changes in two subsequent days—up 3% on Wednesday and down 3.6% on Thursday.  Year-to-date price volatility has increased.  Which leads us to look at the value of monitoring the 12-month forward P/E ratio.

S&P 500 Forward P/E Ratio

Chart of S&P 500 Forward P/E Ratio

The Forward P/E Ratio Today

The P/E ratio has declined by 20% from its January peak (17.2 vs. 21.6).  Most of the decline is due to lower stock prices (down 13%).  The rest of the lower P/E ratio is explained by higher earnings expectations.  Forecasts for 2022 are little changed from January, but remember the 12 month window has rolled forward so forecasted earnings are higher by 9%.

The forward P/E ratio of 17.2 is now back to the peak levels from 2003, 2018, and early 2020, and about 10% above its 20 year average of 15.5.  It is interesting that longer term statistics reveal we are now back to the 35 year average of 17.8.

Average, Minimum, and Maximum Forward P/E Ratio Table

What Is The Forward P/E Telling Us About The Future Of The Stock Market?

No P/E ratio has a good track record as a market timing tool.  We categorize P/E ratios as a good measure of environment risk.  As an example, the forward P/E spiked to 25 in the summer of 2020 with the S&P 500 trading at 3,000.  Stock prices largely looked past the drop in forecasted earnings to a quick recovery.  The S&P 500 index eventually moved higher by 59%.

A high forward P/E indicates that environmental risk is high which translates to stock prices reacting more negatively to external shocks than during periods of lower P/E ratios.  Conversely, when P/E ratios are low, stock prices may not be as vulnerable to bad news and may react more positively to good news. 

Currently, the forward P/E is telling us that a lot of air has been let out of elevated stock prices as the market has reacted to high inflation, a slowing economy, continued supply chain issues, and geopolitical tensions.  If the forward P/E had started the year at 15 (instead of 22), we suspect stock prices may not be down as much as they are today.

Going forward, the key to trends in the P/E ratio (and stock prices) is tied closely to inflation.  The longer inflation persists, the more pressure will bear on the Federal Reserve to raise rates and shrink its balance sheet.  Eventually, these will contribute to reduced liquidity (tighter financial conditions) and slower economic growth. 

Returning to the 20 year average P/E of 15.5 would result in a further 10% decline in stock prices (all other factors being equal).  The long-term upside from inflation is that corporate earnings generally grow with inflation.  This enhances the constant dampener already provided to the forward P/E from growing earnings over time.  Near-term, there are questions developing about the sustainability of current earnings growth rates.  If earnings expectations fall, it would raise the P/E and increase market vulnerability.  The bottom line is that today, the market is relatively less vulnerable to additional external shocks or reduced earnings expectations, but at 17.2 the market is not invincible.

The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.

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