Despite the continued tepid economic outlook, the stock market has seen a significant buildup over the past several years.
The S&P 500 has seen a total return of over 200 percent since the bottom of the recession in 2009. And the index held remarkably stable over the summer, even managing to post all-time closing highs ten times in just the past two months. The buildup, however, has pushed price-to-earnings ratios well above their long-term averages, prompting flashbacks to the dot-com bubble for some.
Price-to-earnings ratios are only part of the picture, however, Doron Nissim is quick to point out. While inflation remains near historic lows there’s no upside to holding cash. And with bond yields still hovering near zero, and even going negative in some countries, investors have far fewer options. That’s fed the significant rise in P/E ratios as investors with no other options become increasingly willing to pay more for even modest returns.
Rising P/E ratios have also pushed out the effective term of equities, as it takes additional years of earnings to recoup the higher prices. For today’s investors, this extended term underscores the importance of sustainable earnings when selecting stocks, Nissim points out. As investors learned earlier this month when stocks took a sudden tumble before slowly clawing their way back, it also means greater uncertainty — and likely greater volatility for the foreseeable future.
Doron Nissim – Professor Nissim earned his Ph.D in Accounting at the University of California, Berkeley, and joined Columbia Business School in 1997.
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