The S&P500 had a breath-taking recovery after its March dip and recorded the shortest and the most impressive rebound in history following a bear market. The index rallied nearly 60% in five months following the March dip as investors rushed to buy US stocks at discount. But not all companies benefited equally from this market rally. The S&P500’s V-shaped correction has in fact hidden a very uneven recovery. Most companies did badly through the Covid crisis, but their morose performances remained under the shadow of the big caps’ shine.
Big tech companies which have a dominant impact on the cap-weighted S&P500 index introduced a heavy bias in the headline index performances.
FAANG stocks (Facebook, Amazon, Apple, Netflix and Google parent Alphabet) together with Microsoft make up to 25% of the S&P500 index. All, except from Alphabet, rallied to record high levels as the pandemic boosted demand in online products and services. The FAANG’s combined performance exceeded 70% between March and August, while the remaining 495 companies in the S&P500 performed near 45%.
On the other end of the spectrum, the smaller companies displayed a much less impressive performance during the same period. The Russell 2000 index, which is composed of the 2000 smallest caps in the US, remained below its February levels, just before the Covid-led sell-off started.
The new equity market narrative is therefore a ‘K-shaped’ correction, which adds the missing leg to the so-called ‘V-shape’, referring to those companies that have seen their share prices tumbling as a result of a severe slowdown in economic activity, and did not have a chance to recover as fast as did their big cap counterparts.
As a result, the big companies got bigger, the small companies got smaller.
Some big companies’ price levels shot up to questionable levels, as even with the increased pandemic-led demand, their earnings didn’t keep up with their skyrocketing stock prices.
P/E ratios shoot up.
The price-to-earnings ratio is one of the most popular metrics for valuing companies’ stock prices. As its name indicates, it is a company’s share price relative to its earnings per share.
Investors use the P/E ratio to judge whether the share price of a company is too high, or too low compared to its own historical values, or compared to similar companies’ share prices. It is a very commonly used comparative analysis tool.
The historical mean for the S&P500 P/E ratio is 15.81, meaning that on average the S&P500 trades 15.81 higher than the underlying company earnings. But this ratio has currently risen to 30, almost twice as the historical average, as a result of a breathtaking rally in leading US stock prices fueled by unprecedented monetary and fiscal stimuli.
And, the most popular US companies’ P/E ratios are currently well above the S&P500’s already above-the-average P/E. At the time of writing, Alphabet, Facebook and Microsoft’s P/E ratios stand at 33, 34 and 38 respectively. Netflix’s P/E ratio is 82 and Amazon’s 126.
If we look at more extreme numbers, Tesla’s P/E ratio shot up to 1000 and Zoom’s exceeded 1600.
What could it mean for the future of market prices?
For investors who base their decisions on the P/E ratios, there is no simple rule of thumb.
A low P/E ratio could mean that a stock’s price is undervalued, so it could act as a signal for betting on an upside correction. But it could also mean that investors expect lower returns in the future, which would be a reason to sell the company’s shares.
Likewise, a high P/E ratio could hint that a company’s stock price may have gone too high, so it would be interesting to bet on a downside correction and to sell the stock. But it could also mean that investors expect higher growth rates and robust returns in the future, therefore it could also justify opening a long position to benefit from further gains.
In summary, it is up to investors’ gut feeling. A skyrocketing P/E ratio does not necessarily mean that the stock price would be dragged lower in the future, although the off-the-roof ratios do ring the alarm bell.
Looking to the historical data, the only times the S&P500’s P/E ratio printed abnormally high levels coincide with previous financial crisis. The P/E approached the 45 level right after the 2000s dot.com bubble, and shot up to 123.73 in May 2009, following the subprime crisis which brought the Federal Reserve to open Pandora’s box to prevent the financial markets from collapsing as earnings declined.
Each time, however, the S&P500’s P/E ratio ended up returning to reasonable levels, mostly due to a rebound in earnings rather than a retreat in asset prices as the S&P500 kept on climbing to uncharted territories.
Therefore, a reasonable expectation would be that the P/E ratios come back to their historical levels, not necessarily driven by price pullbacks, but also with improved earnings as the Covid dust settles.
But it is unsure whether the big tech companies could deliver such ambitious results that would justify their prices being up to 100, 1000 and even 1500 times their earnings.
Therefore, the most realistic expectation would be a downside correction in big tech stock prices combined to an overperformance in laggards’ as the economic recovery settles in.
But given the disturbed market dynamics, it could take long before the market comes back to its senses. Hence, the big tech rally could continue supporting the misleading perception of V-shape correction in US equities, as central banks and governments continue pumping in money hoping that those companies that stand at the bottom of the list could also make their way out of the pandemic-led economic turmoil.