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Monday, April 5, 2021

Valuations aside, stocks are up because earnings are up

Stocks hit new record highs on Thursday with the S&P 500 (^GSPC) crossing 4,000 for the first time ever to close at 4,019.

Why are stocks up? It's simple. Earnings are up.

While that might sound silly in its simplicity, it's worth stating. Especially as market naysayers sound alarms about valuations as measured by price/earnings (P/E) multiples.

Sure, valuations are and have been elevated. But recent fluctuations in P/E multiples are nothing compared to the magnitude of the rebound in earnings. Credit Suisse's top U.S. equity strategist Jonathan Golub puts a spotlight on this in his latest note to clients.

"Despite the damage inflicted by COVID, stock multiples rose from 18.2x at the start of last year to 21.8x today, well above long-term averages, and the highest level in over 50 years, excluding the Internet bubble period," Golub wrote on Thursday.

"Since last June, 10-year Treasury yields have increased by 100 basis points (from 0.7% to 1.7%), leading many investors to question the sustainability of these elevated stock multiples," he added. "Surprisingly, valuations have remained virtually unchanged over the past 9 months, as tighter credit spreads have largely offset rising treasury yields." (Emphasis ours.)

With that set up, Golub shared this chart showing the progression of the S&P 500 index, S&P 500 forward earnings, and the S&P 500 forward P/E multiple.

We often see charts overlaying one or two of these metrics. But including all three proved insightful.

"As the exhibit [above] shows, with multiples stable, the market’s entire advance can be explained by improving earnings," he said.

We're not exactly breaking news here. Myles Udland wrote about this in December in his reflection on 2020. Pointing to a chart similar to the one above, Myles noted that stocks fell when earnings fell, and "the market’s bottom coincides with a turnaround in earnings expectations for 2021. A turnaround that has not yet leveled out."

In other words, direction matters.

Oftentimes, valuations will fluctuate as it may take time for earnings to catch up with stocks or for stocks to catch up with earnings. But as long as the direction of earnings is expected to be up, it shouldn't be a surprise to see stocks going up.

"For stock market investors, a critical metric to watch is expectations for future earnings," DataTrek Research's Nicholas Colas said recently in research which we cited in the Morning Brief.

And like we noted in that Brief, the recent stalling of those expectations bears watching. But for now, expectations are for earnings to keep going up.

Something worth reiterating

It's tempting to think that if P/E multiples are elevated, then stocks are increasingly likely to go down because valuations should revert to some long-term average.

But it's just not that simple.

Rising stock prices can come with falling valuations if earnings are growing at a faster clip. Similarly, falling stock prices could come with rising valuations if earnings are falling faster than stocks. That's just math. (And to complicate matters further, valuations don't actually appear to be mean-reverting.)

As Golub observed, what we've been witnessing is elevated valuations effectively make no movement for months. But the same can't be said about stocks.

The worrywarts sounding alarms about P/Es just above 20 as the S&P 500 crossed 4,000 were screaming about P/Es just above 20 when the S&P was at 3,000. If elevated valuations kept you out of the market, you might've missed out on some of the greatest market returns in history.

High valuations alone are no reason to expect stocks to fall in the near term. And as we've written recently, time in the stock market matters, and the longer you're willing to hold, the less likely it is you'll be recognizing losses.

By Sam Ro, managing editor. Follow him at @SamRo

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