There are times when you look at the headlines and find yourself scratching your head wondering why the market is going up. It could be the macroeconomic landscape, the political environment or the sentiment of those around you. Regardless of the external factors, there is arguably one fundamental force that drives stock prices. Earnings. Generally speaking, if companies are growing earnings and not giving guidance that would indicate that the trend will change, stock prices usually follow.

This makes it sound easy to predict stock prices. However, by the time you hear the report, the stock price is already moving. Due to insider trading laws, companies have guidelines to follow about releasing information to the public, so we all find out at the same time. If a company beats earnings expectations, then the stock may move higher and if they miss earnings expectations, then it may move lower. The plot thickens though. Earnings are the report card for the prior quarter. Guidance is what the company expects to do in the coming quarters. If the company provides soft guidance, that can overshadow a good earnings report because stock prices are forward looking.

You may hear the experts referring to multiples when they are talking about stocks. They are referring to the price a stock is trading at relative to its earnings or the Price to Earnings Ratio (P/E). This is simply calculated by dividing the current stock price by the most recent earnings per share. The general rule of thumb is that a low P/E can indicate that a stock is undervalued, and a high P/E can indicate that a stock is overvalued. To take it a step further, the Forward P/E substitutes projected earnings for the most recent earnings to give you an idea of where a stock is trading relative to earnings expectations.

What is a high P/E and what is a low P/E? This is where it gets tricky. You can look at historical averages, but different cycles have different averages. Furthermore, it really depends on the multiple the market will pay for a given stock. The darlings of Wall Street right now referred to as the Magnificent 7 (Mag 7) all trade at much higher multiples than your average stock. For example, as of this writing, the S&P 500 is trading at a Forward P/E of approximately 22. Amazon is trading at a Forward P/E of approximately 34. That is actually low relative to historical averages for Amazon but is still high relative to the market. If you only used P/E as the metric to measure Amazon’s value, you likely would never have considered purchasing it. Despite that, the stock has performed incredibly well over the years.

Contrarily, stocks trading at low multiples can often be referred to as value traps. Let’s take Verizon as an example. The stock is trading at a Forward P/E of a little less than 9, which is right in line with its average of the last 5 years. In that time period, the stock has yielded a negative return. Even though the stock looks cheap, it is trading at a low multiple for a reason. Fortunately for the S&P 500, Amazon makes up a much larger share of the index than Verizon.

In reverting back to the title of the article, earnings do drive markets. As long as earnings are growing, markets should keep growing with them until there is reason to believe that the earnings growth will slow down or decline. Unfortunately, the reason often comes out of left field when you least expect it. That’s what makes markets so unpredictable. You never know what premium the market will pay for stocks and for how long. This is another illustration of why we are much better off diversifying, maintaining our discipline, and focusing on the long term.

Sources:

FactSet Research

Morningstar

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