Do I want to spend time and energy to learn a new style of investing at the age of 41? Well, maybe. Because I’m weird. But really I’d prefer to keep my 10 year old asset allocation plan and just keep buying the same assets, like the S&P 500. The problem is, I’m concerned that the S&P 500 is overvalued right now. Not by 10 or 20%, but more like 80%. At a current P/E of 29, it would take tremendous growth or a lot of time to bring that P/E back down to a more manageable level.
Why do I care about the price to earnings ratio of the S&P 500? Does it even matter?
Maybe not in the near term. I believe that index funds and auto investing has millions of people blindly purchasing the S&P 500. As long as that continues, the price of the S&P 500 doesn’t matter. The P/E doesn’t matter. All that matters is that people believe the price will continue to go up. That type of investing makes my skin crawl though. While it has been a wonderful way to invest for the last ten years, I can’t imagine it will always be that way. At some point, I believe non-collectable assets come back towards the price they are worth based on the cash flow they can provide.
So what P/E would I like to see for the S&P 500?
According to this source, the average growth rate of the S&P 500’s earnings is 7.6% for the last 18 years. So in general, we can expect the S&P 500 to grow earnings at 7.6%. Now let’s turn the S&P 500 into company Z. Company Z has a long track record of growing at 7.6%. And you have supreme faith it will continue to do so. More so than any other business on planet earth. How much should we pay for stock in company Z? If this were a run of the mill company, paying more than 10 times earnings would be a bit rich. Where does that 10 times earnings come from? Good question. The answer is that business trade hands from one owner to the next. In general, people don’t want to buy a business and pay more than a few years of profit for it. For instance, if company Z currently makes $100/yr, if it doesn’t grow at all, it would take 10 years to breakeven on a $1000 investment (which is a P/E of 10). Now, we believe company Z will actually grow at 7.6%/yr which will shorten the amount of time it takes to breakeven by 2.5 years or 7.5 years total. That’s not all that bad, but it is probably no the high end for private business transactions. A breakeven of three years is not unusual. However, I think we can all agree that company Z is special because it is the best company to own in the world. So a premium can and should be warranted. I’d argue a breakeven time of ten years would be tolerable for such a special investment. The ten year breakeven at 7.6% growth is a P/E of 15. At a P/E of 29, the breakeven time on your investment would be 15.5 years assuming the same 7.5% growth rate. That’s a long, long time. Is a 90% premium warranted? I personally don’t think so. No matter how great a company is, I don’t want to buy it fully expecting it to be 15.5 years before I see my first dollar of profit. There just has to be a better deal out there.
So where does this analysis leave me?
I believe my analysis is accurate. That doesn’t mean the S&P 500 won’t be a wonderful investment for decades to come, but I do think that if it is a wonderful investment, it won’t be because of fundamentals. As such, I’ve spent a few months reading financial books in the hopes of finding a better methodology than continuing to blindly buy the S&P 500, and I’ve found the path I’m going to take. You are welcome to follow along.