How Much Gas Is In the Stock Market Tank?

Market Insights

July 27, 2017

How Much Gas Is In the Stock Market Tank?

Year-to-date, the S&P 500 is up roughly 11.5%. Just in the last week, it gained 1.2%. How much further can it run?

The value of stocks is positively related to increases in future corporate earnings and negatively related to increases in the risk premium. It is intuitive that if earnings rise, stocks should rise. What may not be as obvious is the effect of risk premium. A simple way to think of the risk premium is if investors become anxious, they may sell risk assets (stocks). If investors have confidence in their positive views of the future, they may buy risk assets (stocks).

When the P/E is constant, it says that the risk premium is constant. What is driving the value of stocks when the P/E multiple is steady are changes in earnings.

Since the end of 2015, the average P/E of the S&P 500 has been 21. The variance around this average has been tiny at 3.2% or less. In other words, the P/E has been essentially a constant for the past year and a half.

To make clear the point, stock prices were almost entirely driven by earnings gains over the past eighteen months: The S&P 500 appreciated by 18.6% and earnings, from the $98.61 low, advanced by 18.0%.

What would happen to the S&P 500 index if the P/E were to remain constant at 21 for another eighteen months?

By New Year’s Eve 2018, an investor in the S&P 500 may gain 23.5% appreciation based on earnings growth, all else being equal.

The stock market almost never advances in a straight line. The complex world we live in today has a tremendous capacity to create investor anxiety and changes in the P/E and risk premium. But with no signs of a recession on the intermediate term horizon, it is quite possible stocks continue to follow earnings higher.

We invite you to give us a call at (415) 249-6337, visit www.uscapitalwm.com or email us at info@uscapitalwm.com if you have questions about how we may assist you in managing your investment accounts.

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How Much Gas Is In the Stock Market Tank?

US Capital Partners

Pursuant to the provisions of Rule 206(4)-1 of the Investment Advisors Act of 1940, we advise all readers to recognize that they should not assume that recommendations made in the future will be profitable or will equal the performance of past recommendations. This publication is not a solicitation to buy or offer to sell any of the securities listed or reviewed herein. The contents of this letter have been compiled from original and published sources believed to be reliable, but are not guaranteed as to accuracy or completeness. Nicholas Atkeson and Andrew Houghton are also principals of US Capital Wealth Management, a registered investment advisor. Clients of US Capital Wealth Management and individuals associated with US Capital Wealth Management may have positions in and may from time to time make purchases or sales of securities mentioned herein.

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