I I have always thought that a friend was representative of many typical investors. We talk about the stock market frequently, but there’s one thing I always know will trigger a call: when there’s a big down day on the Dow, I can be pretty sure it’ll pick up. the phone. By now, experience should have taught him that big intraday dips are almost always short-term affairs and riding them out is simply the best strategy. But still, when the headlines in the financial media are full of pessimism and the Dow Jones is down, he worries.
I was therefore surprised to receive a call from him yesterday, when the market was quite stable after four consecutive days of good gains. He had found something else to worry about and called to ask a question that I realized was on many people’s minds: why are stocks bouncing when there are so many bad news ?
It would seem fair to ask. After all, there is bad news on just about every front. Geopolitically, Russia has invaded Ukraine, and the courageous resistance of the Ukrainian people gives the impression that it will not be over anytime soon. This has the capacity to either escalate into a major global conflict or drag on for years. Either outcome would be first and foremost a human tragedy, but it would also suck money out of the global financial system and massively slow growth. This is pretty bad news for equities, but taking into account the wildcard of China’s reaction, it could get even worse.
Then there is monetary policy.
For years, I and many others have said that the biggest support factor for equities is accommodative monetary policy. Extremely low interest rates and a market buzzing with cash meant stocks were attractive relative to bonds and banks had plenty of cash at their disposal. The market inevitably rose. Those conditions are changing, with the Fed heading into a period of rate hikes and discussing how it will make up for its delay in reacting to inflation by now being tough. If low rates and easy money have driven the market for so long, shouldn’t a complete reversal of these policies send us back to where we started?
If this is true and given the risks associated with the invasion of Ukraine, why has the Dow Jones rebounded 7% from the low? Why is the index just six percent below all-time highs?
The answer to both questions is simple: profits. When you buy a stock, you are buying a share of a company’s prospects and earnings. All of the issues described above affect future prospects, things that may happen in the future, but that doesn’t mean we can ignore what really happened in the recent past: massive increases in profits companies.
We have just completed an earnings season that has given us a fourth straight quarter of earnings growth of over 30%. This is partly because earnings were still negatively impacted by covid a year ago, but at that time the impact was not that significant. American businesses have faced tremendous challenges and have adapted and thrived. Many CEOs have been cautious about the rest of the year, which is understandable, but that caution is fully priced in. average for the Dow is now 18.
More importantly, from a stock valuation perspective, this happened as stock prices fell. This has resulted in a significant shift in the most important stock valuation measure, the price-to-earnings ratio, or P/E. If prices go down and earnings go up at the same time, the P/E will drop significantly, and that’s what we’ve seen. A year ago, the Dow Jones Industrial Average PER was 32.91, while yesterday’s close was 19.33. That’s still a bit above the long-term average, but given that growth has accelerated so much over the last decade or so due to automation and other efficiency improvements, that seems quite reasonable. You could even say it looks cheap.
There are risks, of course, and if they go wrong, stocks will fall even further later this year. The market, however, will deal with these issues when and if they arise. For now, American companies are once again showing that they are strong, innovative and adaptable, and that they can make money no matter what. As long as this is the case, even a news cycle dominated by pessimism cannot shake stocks too much, and every sell-off will prompt buying.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.