Commentary on financial markets – July 2017
Highlights:
- Oil price up 9.9% in July
- USA: economy thrives, employment rises, P/E ratio at 24.65
Commentary:
No news, good news. That is how one could sum up the trading on the financial markets in July. The VIX fear indicator for the S&P 500 index is at its ten-year low and is holding near 10 points. Overseas markets are at record highs. The high valuation of equities is due to the accommodative monetary policy of central banks and the good health of the US economy. US industry is also doing well, with new and export orders rising and unemployment falling.
The easing of global tensions is also contributing to the optimism. The existence of the self-proclaimed Islamic State appears to be coming to an end and tensions in Syria are also easing. While it is true that tensions have increased on the Korean peninsula and further sanctions have been imposed on Russia by the US, an attack by the DPRK is unlikely and Russia has little scope to damage Western interests economically. Indeed, Russia’s economy is the size of California’s and Russia’s only economic weapon would be to stop exporting energy resources, which would perhaps harm Russia itself even more.
US stocks in the S&P 500 index are now trading at a valuation P/E multiple of 24.65. This means that with the current profitability of US companies, overseas stocks are quite expensive.
Investor’s School – P/E ratio:
The P/E ratio compares a stock’s current market price (P=price) to the company’s last published earnings (E=earnings). The P/E ratio actually tells us how many monetary units an investor is willing to pay per unit of earnings. The lower the ratio is, the more attractive the stock currently is and vice versa. However, the P/E ratio has one major weakness, of course, and that is that it only takes into account the current earnings of the company. No one knows future earnings, but they are nevertheless crucial in stock valuation. It is true that with stocks we always buy the future (which nobody knows, we can only guess) rather than the present (which everybody knows).
Thus, the use of the P/E ratio will be different for companies in the pioneering stage of conquering a new market, different in the development stage and different in the stabilization stage of the company. It is clear that in the pioneer or development stage, a firm’s profits are very small, and yet its stock can be relatively very expensive. This is because of the expectation of future profits. Facebook shares are an example. The P/E ratio for this stock is currently 42.04. This means that investors have to pay 42 times for a unit of current earnings. Or to put it another way – that the share price will be paid back from current earnings in 42 years! That would not be a good investment at all. But the joke is that investors are expecting significant growth in future profits because they are betting that many (young) people spend a lot of time on Facebook, making Facebook an ideal space for targeted advertising.
A counterexample might be the use of this indicator for a stabilized firm. Here, the advantage is that the stabilized firm is usually in a market that is no longer growing significantly and the major players maintain their positions. As a result, the firm’s profits do not change much. The mobile operator O2 in the Czech Republic is an example. The mobile operator market is saturated, there are three major players and their profits are stable. Thus, O2 CR shares are currently trading at a P/E of 16.45.
The P/E ratio can be used not only to analyse individual stocks, but can also be used for a quick market assessment. In the commentary, it was stated that the current P/E ratio of US z shares is at 24.65. This indicates that US stocks are now relatively expensive as the long-term average is 15.66.
However, we still have to keep in mind that the P/E ratio in our example only works with the current earnings of US companies and the question remains how much they can increase their profitability in the future. If they can, current US stock prices may not be high either. If not, then sooner or later there must be a price correction.