It’s a debate raging across the country that seemingly everyone has an opinion about. From Main Street to Wall Street, everyone wants to know; will the U.S. stock market suffer a severe correction or keep grinding higher?
Let’s examine a couple of valid arguments why the U.S. stock market might keep charging higher between now and the end of the year.
Reason #1: Earnings have come roaring back from the recent pandemic induced recession. EPS (Earnings Per Share) on the S&P 500 are at an all-time high. The 500 largest public companies in the U.S. generated earnings that are up 29% from pre-pandemic levels (2020) and are up 386% from the depths of the forced shutdown. In a nutshell, the largest U.S. companies have never earned more money than they are earning today. I repeat, the largest U.S. companies have never earned more money than right now. Mic drop.
And it’s growth in earnings per share that drive stock prices up.
See chart below, 32+ years of Earnings Per Share – it’s never been higher.
Reason #2: Interest rates are extremely low (from a historical perspective). Interest rates to valuations are like what gravity is to matter, they are inextricably linked. The higher the level of interest rates, the lower the value of future earnings are worth today, and therefore a downward pull on stock prices. At the same time, higher rates add to the interest on mortgages, business loans, and corporate bonds, which makes it more expensive and harder for individuals and businesses to borrow money. With that said, interest rates are at some of the lowest levels going back decades. Take a look at 10-year Treasury rates over the past 30+ years.
Top 2 Reasons the Stock Market Is Overvalued and Might Fall From Here
Reason #1: Valuations are high (at least from a historical perspective). The price-to-earnings ratio (PE ratio) is one metric for valuing a company or an index as it measures a company’s current share price relative to its per-share earnings. PE ratios can be used by investors to compare the relative value of one company’s shares versus another company’s shares or in our case the overall valuation of the market. Currently the market PE is significantly above the 10 year average of 21.30, which could indicate that the market is expensive and needs to come down to a more reasonable level. We’ve all heard the adage, “what goes up, must come down.”
Reason #2: Interest rates have more than doubled in the last year (see chart below). And as stated previously, when interest rates rise, valuations come down. There is a lot of talk about rates continuing to rise especially with the recent rise in inflation.
So there you have it, two compelling reasons why the stock market could continue to rally, and two compelling reasons it won’t.
Understanding all of this, what should you do?
- Make sure your financial plan is up to date.
- Know what you own and why you own it; as not all assets behave similarly under various economic conditions.
- Make sure your investments are consistent with your time horizon and your tolerance for risk.
- Take a deep breath, remain calm, and remember what the 13th century eastern monarch is believed to have been told by a group of wise men who were instructed to come up with a phrase that is true in all times and situations, “this too shall pass.”
-Paul R. Rossi, CFA