A common metric to evaluate investments is the Price to Earnings Ratio (PE Ratio). Imagine buying a company that makes $10,000 a year for $100,000. The PE Ratio would be 10 because a price of $100,000 divided by earnings of $10,000 is 10. If an investor paid $200,000 for the same company, the PE Ratio would be 20 and the possibility for overpayment would have increased. On a historic basis, the stock market (S&P 500®) trades at 15 to 17 times earnings. The fact that the stock market now trades at 25.75 times earnings implies market optimism and an expectation that earnings will increase, corporate costs will decrease, future tax codes will be more favorable, or some combination of positive changes that supports the third highest PE Ratio in 157 years. So is the stock market overvalued? If you are concerned with this question you haven’t thought out your investing strategy enough, are too exposed to the stock market, or improperly hedged to weather the storm. Maybe the optimism is well-founded, maybe next year the market will be flat and earnings will catch up to the recent price appreciation, or maybe the market will revert back to 17 times earnings and drop 41.74%. In the end, a consistent investment strategy is more important than an opinion and building a portfolio with optionable investments gives you options.
