Can Stock Prices Stall Even When Profits Soar?
This fall offered investors a puzzle: Corporate America was having one of its best stretches in years, with S&P 500 companies on pace for a third straight quarter of earnings growth above 25 percent. Over the summer, analysts raised their profit expectations for the coming year by nearly 9 percent.
The stock market barely noticed. Over the same period, the index rose less than 2 percent.
If stock prices follow profits, that gap should not exist. But it did exist, because stock prices follow something else as well: the price investors are willing to pay for each dollar of profit. That price is falling.
What a P/E Ratio Really Measures
A price-to-earnings ratio is a simple idea. It tells you how many dollars investors will pay today for one dollar of a company’s annual earnings. A P/E of 20 means investors are paying $20 for every $1 of profit.
That willingness to pay isn’t fixed, obviously. It depends heavily on the alternative opportunities, and the baseline alternative is the return available from risk-free, or nearly risk-free, investments. When a 10-year Treasury bond paid 2 percent, stocks faced little competition. Investors could justify paying a premium for future growth because the safe option offered so little, and particularly so after adjusting for inflation.
This summer, the 10-year Treasury yield topped 5 percent. A guaranteed 5 percent changes the math. A dollar of profit that a company will earn five or ten years from now is worth less today when the safe alternative pays that much. Investors respond by paying less for every dollar of earnings, and P/E ratios contract.
That is what happened. The forward P/E ratio for the S&P 500 fell from above 20 at the end of June to about 19 by mid-September, even as earnings estimates climbed. Profits went up, the multiple came down, and the two nearly cancelled each other out.
Rising Rates and Market Volatility
Early this year, many forecasters expected the Federal Reserve to cut interest rates. By late summer, stubborn inflation, oil above $100 a barrel, and rising bond yields had turned that expectation upside down. On September 16, the Fed raised rates for the first time in more than three years, and markets, according to the punditry, now expect more increases to follow.
Whatever the talking heads say, the Fed’s new chairman, Kevin Warsh, has stopped providing forward guidance, the hints about future moves that markets have relied on for years. Investors who hoped to trade around the Fed’s next decision now have even less to go on.
History offers some perspective. Across seven first rate hikes of a cycle since 1988, the S&P 500 declined an average of 4 percent over the following six weeks, then recovered those losses over the next several weeks. Twelve months later, it was higher in every episode but one. That record argues against panic, but it doesn’t make the path of rates any easier to predict.
What Disciplined Investors Do
Rather than betting on where rates will go next, disciplined investors ask a more useful question: how dependent is my portfolio on any single outcome?
Rising rates don’t affect all stocks equally. Companies whose value rests on profits expected far in the future, often the fastest-growing and most richly valued, tend to feel rate increases most. The reason is arithmetic: the further away a profit is, the more a higher interest rate reduces what it is worth today. Companies with steady current earnings and modest valuations tend to feel them least. A portfolio concentrated in the first group is making an unspoken bet on falling rates, whether its owner realizes it or not.
The answer isn’t to predict the Fed. It is to know what you own, understand how much risk it carries, and diversify so no single forecast has to come true for the plan to work.
Financial Gravity’s Real Risk Meter™ measures risk exposure directly, showing how much risk your portfolio carries along with how much you can tolerate, including in a Bear market. It is the logical next step after a Taxes First, Then Math™ Analysis, a no-cost review of your investment statements that shows where you may be paying more in taxes and fees than you need to, potential tax savings, and a precise percentage for your downside risk potential.
Profits may keep rising, but rates may keep rising too. A well-built portfolio doesn’t need to know which will win.
