Stocks hit new record highs on Thursday with the S&P 500 (^GSPC) crossing 4,000 for the first time to close at 4,019.
Why are stocks up? It is simple. Earnings are up.
While that might sound silly in its simplicity, it is worth stating. Especially as market naysayers sound alarms about valuations as measured by Price/Earnings (P/E) multiples.
Sure, valuations are and have been elevated. But recent fluctuations in P/E multiples are nothing compared to the magnitude of the rebound in earnings. Credit Suisse’s top U.S. equity strategist Jonathan Golub puts a spotlight on this in his latest note to clients.
“Despite the damage inflicted by COVID, stock multiples rose from 18.2x at the start of last year to 21.8x today, well above long-term averages, and the highest level in over 50 years, excluding the Internet bubble period,” Golub wrote on Thursday.
“Since last June 10-year Treasury yields have increased by 100 basis points (from 0.7% to 1.7%), leading many investors to question the sustainability of these elevated stock multiples,” he added. “Surprisingly, valuations have remained virtually unchanged over the past 9 months, as tighter credit spreads have largely offset rising treasury yields.”
With that setup, Golub shared this chart showing the progression of the S&P 500 index, S&P 500 forward earnings, and the S&P 500 forward P/E multiple.
We often see charts overlaying one or two of these metrics. But including all three proved insightful.
We are not exactly breaking news here. Myles Udland wrote about this in December in his reflection in 2020. Pointing to a chart like the one above, Myles noted that stocks fell when earnings fell, and “the market’s bottom coincides with a turnaround in earnings expectations for 2021. A turnaround that has not yet leveled out.”
In other words, direction matters.
Oftentimes, valuations will fluctuate as it may take time for earnings to catch up with stocks or for stocks to catch up with earnings. But if the direction of earnings is expected to be up, it shouldn’t be a surprise to see stocks going up.
And like we noted in that Brief, the recent stalling of those expectations’ bears watching. But for now, expectations are for earnings to keep going up.
Something worth reiterating:
It’s tempting to think that if P/E multiples are elevated, then stocks are increasingly likely to go down because valuations should revert to some long-term average.
But it is just not that simple.
Rising stock prices can come with falling valuations if earnings are growing at a faster clip. Similarly, falling stock prices could come with rising valuations if earnings are falling faster than stocks. That’s just math. (And to complicate matters further, valuations don’t actually appear to be mean reverting.)
As Golub observed, what we have been witnessing is elevated valuations effectively not move for months. But the same cannot be said about stocks.
The worrywarts sounding alarms about P/Es just above 20 as the S&P 500 crossed 4,000 were screaming about P/Es just above 20 when the S&P was at 3,000. If elevated valuations kept you out of the market, you might have missed out on some of the greatest market returns in history.
High valuations alone are no reason to expect stocks to fall in the near term. And as we have written recently, time in the stock market matters, and the longer you are willing to hold, the less likely it is you’ll be recognizing losses.
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