It is common knowledge that stock prices are based on company earnings and earnings potential. The metric often used is the P/E ratio or the Price to Earnings ratio where a stocks price is divided by the company earnings. The higher the future earnings potential the higher the stock price as investor bid up the price of shares in expectation of future earnings streams. For this reason you often witness high flying stocks with P/E ratios at 200 plus and growth rates to match while low growth stocks often only command P/E ratios in the low double digits. Mature companies that make up the S&P 500 usually hover around 15 which is considered a normal price level. Anything higher than this number shows a market that is overvalued and lower than that shows a market that might be a buying opportunity. This is all very basic and cut and dry but the market is anything but that as people's expectations of economic growth and their confidence dictate how high or low the market can go. One thing that shines through is that the earnings of companies dictate the price of the stock and this determines the direction of the market.
Looking at the earnings coming out of the S&P 500 during the past few weeks and it is clear that company earnings are slowing. With it the market is gasping for air and the oxygen is being provided by repeated Federal Reserve stimulus packages and low interest rates. It is hoped that this stimulus will keep a bull market that by any metrics is very long in the tooth afloat, but as the graph below shows this is a long shot. (The chart is provided by href
='http://www.macrotrends.net/1324/s-p-500-earnings-history'>Source: MacroTrends)
The dark line is the S&P 500 index while the light line is the S&P 500 earnings. As you can see the market moves in tandem with earnings. You may also notice that the company earnings have faltered in recent quarters and that this is the first time that this has happened since the beginning of the recovery. Admittedly earnings were incredibly low at the trough in 2009 but still to recover to new highs in such a quick time was incredible and could not be sustained.
The issue as I mentioned above is that when things are good and expected to continue, investors pay up for the promise of future growth. This translates into a P/E in excess of 15. At present and based on the current market price the S&P 500 P/E stands at roughly 22 well above its normal price. This must mean that the market expects earnings growth to continue to accelerate to new highs. Should this perception be met with continued poor earnings then the reverse will occur and the P/E will drop to below 15 plus earnings contraction will take the index even lower, the so called double whammy. Assuming that earnings contract to $90 (from $94) and the P/E ratio falls to 15 (I do not want to get overly aggressive) then the S&P 500 index would fall to 1,350 from 2,200 or 40%.
As I cannot see why earnings will resume any time soon I have to conclude that this is more than probable and that the market is being held together with Federal Reserve loose money policies and at some point these too must end!
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