Higher prices throughout the economy, higher interest rates from the Federal Reserve, and the ongoing Russian war on Ukraine make market participants quite uneasy. And with this uneasiness, the market continues its relentless dive from all-time highs in early January. We know that markets go up and markets go down and this down period will ultimately end – we just don’t know when that will be. The current correction (bear market or whatever you want to call it) has been going on longer than usual, so I’m hopeful we’re closer to the end than the beginning. We’ll see.
At a time like this, it’s important to remember that a company’s stock price is impacted by several factors. One is its earnings (profit) per share; another is what investors are willing to pay today for those earnings. This second factor is called a stock’s multiple. Let’s say that Apple stock is expected to earn $6.25 in profits per share over the next 12 months and the stock is trading at $134 per share. The multiple is $134 divided by $6.25, which is a bit less than 21.5. This number is also called the P/E ratio (price/earnings).
Multiples for individual stocks, or even the overall market, change based on what’s happening in the world. During periods of faster growth or low interest rates, multiples tend to go up – investors pay more for future earning because those earnings are growing faster than normal. During periods of higher inflation or higher interest rates or both (like now), multiples tend to go down as investors are either concerned about future earnings, or the value of future earnings decline as interest rates go up.
Below is a chart that shows what’s happened so far this year. The upward sloping gray line shows S&P 500 earnings (YTD) – up 6.4%. That’s good! But the blue line shows a substantial decline in the multiple – down 24.6% YTD. Put those two things together and the green line shows the price return of the S&P 500 – down 18.2% (as of Friday afternoon).
This 5+ month slide in the market is primarily the result of a contraction in the stock multiple as opposed to a recession in corporate profits.
What happens next? We’ll have to wait for mid-July to get the next round of corporate earnings. If companies continue to grow their earnings, then even if the multiple stays at this lower level, the market can move higher. Most analysts expect earnings growth over the next several years; if that comes to pass, that is certainly supportive of the market.
Another encouraging aspect of today’s market is that many of the largest S&P 500 companies have substantial stock buy-back programs in place. That means that companies have allocated their own cash to buy back outstanding shares of stock. And when a company’s stock price is down, like now, it can buy back even more shares for the dollars available to spend. Stock buy-back programs typically result in increased earnings per share and therefore increasing stock prices.
Periods like these are never fun and never easy for investors, but it is important to remember a long-term fundamental of the market: increasing corporate earnings ultimately powers through negative sentiment to lift stock prices. That’s what we’re looking for now.
If you have questions or would like to chat, please let me know.
