One of the indices that can be looked at in order to get an estimate of where the market is in terms of pricing is the profit multiplier of the P&S 500 index. This profit multiplier is the ratio of the value of all the companies that make up the index to their annual net profit.
When the multiplier is high, the profit yield (the inverse of the multiplier) is low, and it is said that the market is priced expensively. When the multiplier is low, the profit yield is high, and it is said that the market is sold cheaply.
To get a proportion of where we are in terms of pricing, you can look at the following chart.
Green- annual PE, pink- average PE for 20 years.
In general, for years, the profit multiplier has been bouncy, but historically, the graph can be divided into two parts.
In the 20th century, we were in a pricing environment of around 15, while in the 21st century, we are in a higher pricing environment of around 22. The reason is that the world has become more technological, which has affected companies’ profitability and growth rates.
At the end of 2021, we were at a very high-profit multiplier of35; since then, it has declined, and today it stands at 21.
This means that indices are more or less priced where they should be. As a matter of fact, the stock market is not cheap, but it is not a bubble either.
Indices have a limited upside to rise from the current price point. Therefore, at the current pricing point of the market, there is a preference for an active launch in growth stocks over passive investment in indices.
The following post will talk about the yield on profit in the bond market, explain why it serves as a reference through which investors price the stock market, and compare the profit yield of the capital market against the bond market.