be_ixf;ym_202104 d_12; ct_50

Select Page

Stocks Are 40% Undervalued Right Now

Stocks Are 40% Undervalued Right Now

The bears have great arguments in the current market. Among the most interesting is that stocks are overvalued. But with interest rates where they are, stocks are deeply undervalued.

The chart below shows the actual price-to-earnings (P/E) ratio of the S&P 500 and the justified P/E ratio, which is the fair value of the ratio based on interest rates.

With interest rates where they are, stocks are deeply undervalued.

The current P/E ratio is 26.9. That’s higher than average, and that has the bears worried.

Legendary investor Warren Buffett’s teacher, Ben Graham, taught that the proper P/E ratio depended on interest rates. He wrote that the P/E ratio should be equal to the inverse of the long-term interest rate.

This sounds confusing, but it’s easy to understand. That relationship is based on the idea that stocks and bonds are alternative investments. Graham developed this idea in the 1930s, when stocks and bonds were direct alternatives.

Graham believed investors should buy stocks only when the company earned more than bonds paid. Bonds pay an interest rate. The equivalent measure for stocks is the earnings yield.

The earnings yield is the earnings per share divided by the stock’s price. Mathematically, that’s the E/P ratio. It’s also called the justified P/E ratio. This lets us determine what the right ratio for stocks is.

If we know the current interest rate, dividing that rate by one tells us what the fair value of the P/E ratio should be. With low rates, the fair value of the P/E ratio is high. In fact, it’s about 44 right now.

It looks like rates are rising. As this happens, the fair value of the P/E ratio, or the justified P/E ratio, will fall. If 10-year Treasury rates rise by 0.5%, the justified P/E ratio falls to about 35.

This all means stocks have significant upside potential. Low interest rates and high earnings growth point to higher prices in the stock market.

There’s no need to worry about valuation for now.

Regards,

Michael Carr, CMT
Editor, Peak Velocity Trader

Newsletter Sign Up

Sponsored

MEET OUR EXPERTS

WHAT READERS ARE SAYING..

“I'm very Happy with your services. I hope you don't plan to retire any time soon! My retirement portfolio depends on your expert guidance. Keep up the great work! Thanks.”

- Randy

"You told me to ignore the noise on Wall Street. And thanks to you, I started towards the end of 2016 with $200,000 in my account and I recently put in an extra $100,000. [As of February 2019] My account is worth $500,788! I would’ve missed out if I followed conventional wisdom."

- Helen C.

“Loving the 238% gain after I bought your recommendation in Sept. 2019! This week (July 21, 2020) will be my 1 year anniversary with your amazing team … thanks for the life-changing work you all do! Between all your services, 14 triple-digit gains, the greatest at 358%!"

- Matt

Share This