The upcoming month is a crucial time for the stock market, with a series of events that will make an impact. They come at a time when valuations are rich for equities. I’ll discuss a market hedge if things don’t work out perfectly for the bulls. Equity market valuation metrics are financial ratios and indicators used to assess the value of a company’s stock relative to its earnings, assets, sales, or other key financial measures. These metrics help investors determine whether a stock is overvalued, undervalued, or fairly valued compared to its historical performance, peers, or the broader market. The most commonly cited equity valuation metric is the price-to-earnings (P/E) ratio. The P/E ratio measures the price investors are willing to pay for each dollar of earnings. It is calculated as the stock price (or index level) divided by earnings per share (EPS). A high P/E can indicate overvaluation but can also indicate growth potential. Many growth companies, especially in sectors like technology, have high P/E ratios because investors are betting future earnings may grow significantly. Similarly, a low P/E may signal undervaluation, but it can also suggest that the market expects slower future growth or other risks such as declining earnings, management issues, or competitive threats. Low P/E ratios are also frequently seen in companies with cyclical earnings, which see greater earnings volatility. Looking only at the P/E ratio, cyclical businesses may appear undervalued in above-average earnings periods and overvalued when earnings are weak. Is overall market overvalued? Valuation metrics may also be applied to the overall market. A broad-based stock market index, such as the S & P 500, includes various businesses: fast-growing technology companies, staples and utilities companies, and cyclical firms such as homebuilders, energy companies, and industrials. Consequently, these ratios often provide historical perspectives on whether investors are generally optimistic or pessimistic about growth and whether the stock market is “expensive” or “cheap” compared to its history, other asset classes, or international markets. The S & P 500’s P/E ratio is 26, not the highest it has ever been, but well above average in the chart’s time series going back to January 1991. We need more data points to understand better whether we should interpret this to mean the market is “expensive” at current levels. Why did P/E ratios spike in the past? Was it because the stock market price shot up? Or did earnings plummet? Did those high P/E ratios correspond to lower rates of return for investors in the following months? A quick peek at the history of S & P earnings reveals a couple of things. First, past P/E peaks generally corresponded to steep earnings declines. Second, the massive declines were infrequent, and S & P’s earnings growth resumed after the period of economic distress had passed. The most recent spike in the P/E ratio to above 30 occurred as corporate earnings fell sharply during the pandemic. In late 2008 and early 2009, massive losses by financial institutions dragged down overall corporate earnings, and consequently, the P/E ratio spiked. Note that the chart below depicts S & P earnings on a logarithmic scale —S & P earnings have grown by more than ninefold since January 1991. However, not every period of elevated S & P P/E ratios resulted from earnings declines. Sometimes, stock prices simply rose too far, too fast. For example, the P/E hit 30 in late 1999/early 2000, not because of declining earnings but because of rapidly appreciating stock prices. For better or worse, such is the case today. Over the past two years, S & P earnings have grown from ~$196 “per share” to about $204, an increase of 4%, but the S & P 500 Index has risen by more than 60% over the same period. To be sure, recent economic data has been positive. Friday’s payroll and unemployment data was a notable example. The unemployment rate of 4.1% was below the consensus estimate of 4.2% — a modest beat, but the nonfarm payroll data was the real star. Payrolls of 254,000 sharply beat the consensus estimate of 150,000, and the prior period was revised upward. The labor market, it seems, remains strong. The only fly in the ointment is that the investor enthusiasm that has propelled prices leaves little room for error. If inflation data comes in hot — and we’ll get CPI data on Wednesday and PPI data on Thursday — that could hurt investor expectations for future rate cuts. Earnings season also kicks off in earnest this week, and if results don’t confirm the growth implied by valuations, that too could hit equities. The trade It’s not my habit to encourage investors to short-stock generally. The U.S. economy grows more often than not, and the largest U.S. companies typically grow earnings even faster, but I do periodically encourage tactical hedges. SPY YTD mountain SPDR S & P 500 ETF Trust, YTD Still, there are a lot of critical catalysts on the horizon between now and the end of November: earnings, economy, and election, most notably. Why not purchase a downside SPDR S & P 500 ETF Trust put spread if these cause a pullback? The November month-end SPDR S & P 500 ETF Trust $560/$540 put spread, $20 wide, can be purchased for less than $3.50 per spread. If the market declines by 5.5% or so, the spread would offer a 4.7:1 payoff. Trade example here : Sell Nov. 29 SPY $540 put Buy Nov. 29 SPY $560 put DISCLOSURES: (None) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
