A Different Take on Valuations

Liz Ann Sonders, Charles Schwab’s chief investment strategist, says in her latest market commentary that the recent downturn helped temper some of the investor optimism that was becoming “troublesome”, and that — despite the big gains stocks have made in the past year — stock valuations continue to look attractive.

Sonders’ favorite valuation gauge is the “normalized” price/earnings ratio, which uses four-and-a-half years of historical earnings and two quarters of projected earnings. She also uses the average of reported and operating earnings. Using that approach, she says, “we’re right at the long-term median valuation of just more than 17 times earnings” for the S&P 500.

The market may actually be a bit cheaper than that, Sonders adds, because of inflation (or lack thereof).

She provides a table showing the normalized P/E of the market during different inflationary climates, and in times of tame inflation P/Es have been higher. When inflation has been in the 1% to 2% range, the normalized P/E has averaged 19.8; when it has been in the 2% to 3% range, it has been slightly over 20.

Overall, Sonders sees a fairly bullish picture. “The economic and valuation backdrop for the market remains favorable while monetary conditions continue to be supportive of further gains,” she writes. “Although we recently suffered a correction that approached 10%, it was not only overdue, but helped ease some of the excessive optimism that was becoming troublesome.”