Understanding the PE Ratio and its Implications on Market Analysis
Price-to-earnings ratio (PE ratio) measures the relationship between a company’s stock price and its earnings per share (EPS). In this article, we will analyse a fascinating chart by Apollo Academy depicting the PE ratio of the S&P 500 stocks and explore the implications of this data.
The chart displays the PE ratio of the S&P 500 stocks over a ten-month period. The green line represents the PE ratio for the top seven stocks in the index, which include well-known companies such as Google, Amazon, Apple, Facebook, Meta, and Netflix. The remaining 493 stocks are represented by the darker blue line.
What is intriguing about this chart is the significant increase in the PE ratio of the top seven stocks compared to the rest of the index. Over the last ten months, while the PE ratio of the remaining 493 stocks remained relatively stable, the PE ratio of the top stocks climbed from around 29 to nearly 45, representing a 50% gain. This surge in the price-to-earnings ratio for these stocks has had a substantial impact on the overall market performance.
This challenges the perception that an index, such as the S&P 500, is a cohesive representation of the market. It reveals that within any index, there will always be outliers, with some stocks exhibiting extreme outperformance, while others have significantly lower PE ratios. Therefore, solely relying on the index’s PE ratio to gauge market performance can be misleading.
Similarly, this observation holds true for other indices such as India’s Nifty. The Nifty’s PE ratio, often touted as an indicator for the entire market, is an aggregation of various stock valuations. It fails to account for the wide disparity in PE ratios within the index’s constituent stocks. Consequently, considering the Nifty’s PE ratio as a comprehensive measure of market valuation can be misleading.
In the case of the S&P 500, the market’s performance is highly dependent on the performance of the top seven stocks. If the PE ratio of these stocks had not increased significantly, the market would actually be in a downturn, contradicting the perception of a flat market over the past year. Therefore, it is crucial to exercise caution when analyzing market trends and draw conclusions based on the performance of a few stocks.
The Role of Momentum Portfolios
To navigate these complexities and make informed investment decisions, various investment strategies come into play. Momentum portfolios, for instance, focus on selecting stocks with relative strength and positive price momentum. These portfolios automatically filter out underperforming stocks without delving into their PE ratios.
For instance, in India, our top ten momentum strategy identifies stocks that are performing well and have favorable relative strength indicators. This strategy prioritises stocks based on their upward momentum rather than their PE ratios. By consistently rebalancing the portfolio, removing underperforming stocks, and adding winners, momentum portfolios allow investors to effectively navigate market movements and maximise returns.
This approach presents a unique way to analyse index constituents and identify investable stocks within the index. Instead of relying solely on the index’s composite PE ratio, momentum portfolios consider the relative strength of individual stocks to assemble a high-performing portfolio.
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