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.
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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.
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