Robert T. from Madison, WI asks: Hello Mitch, I hope you had a pleasant Thanksgiving! I’m concerned because this stock market feels way too frothy. I’ve been watching IPOs of companies that don’t make any money go way up, and it feels like the market is moving in one direction (up) while the economy is moving in another. Your thoughts?
Mitch’s Response:
Thank you for sending in your question, Robert, and I hope you had a pleasant Thanksgiving holiday as well! The economy was no doubt a kitchen table issue this year, given all the swirling issues around inflation, supply chains, the stock market, gas prices, and on down the line. I think your question reflects the issues in many Americans’ minds right now.
I will just focus my comments here on the stock market since that is the basis for your question. The S&P 500 – which is a broad index for large U.S. stocks – has been pushing higher all year and has notched to new all-time highs several times throughout 2021. As your question mentions, this strong stock market performance has coincided with an economy seemingly riddled with problems – labor shortages, rising gas and grocery prices, and supply chain challenges.1
The result is the appearance that the stock market is out-of-whack, too frothy.
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But there is a huge component missing from this ‘frothy’ analysis, and I would argue the most important component. It’s the factor I probably write about the most: corporate earnings.
The stock market’s supposed frothiness is sometimes just a gut feeling investors have, but oftentimes it is determined by the market’s P/E ratio. This metric is also known as the stock market’s ‘valuation,’ which investors use to determine if stocks are relatively cheap or relatively expensive. Valuations (P/E ratios) can be determined by looking at the previous 12-months earnings – the trailing 12-month P/E ratio – or the next 12-months estimated earnings, or forward P/E. The latter matters more, in my view, since the stock market is actively discounting future earnings and growth.
If the stock market was indeed too frothy and out-of-whack, we should expect the forward P/E ratio to also be way too high. That would imply that the numerator, price, has moved higher much faster than the denominator, earnings. But that hasn’t happened – valuations are down over the past year! The S&P 500’s forward P/E ratio peaked in early September 2020, at over 30x forward earnings, but has retreated ever since. Today, it is closer to 21x forward earnings, even as the S&P 500 has climbed over 30%. The reason: earnings, and earnings outlooks, have been soaring!
To be fair, I believe certain areas of the market and certain companies are way overvalued. Investors should be very cautious in picking stocks for portfolios. But as a whole, the stock market is not frothy relative to future expected corporate earnings, in my view, and is priced quite fairly. One signal to me that stocks have more wall of worry to climb is that many investors are not only worried but also underemphasizing just how strong earnings are.
Knowing this, it can be hard not to get caught up in the noise, especially when many of the headlines are pushing you to react with fear over potential volatility. But, don’t let this media noise sway your judgment and make you vulnerable to potentially costly financial mistakes.
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Disclosure