Stock prices are based primarily on the earnings of corporations. A company may sell a product or service and either earn money or lose money. If a company earns money on a regular basis, it will remain a viable organization. When a company shows losses on a regular basis, something fundamental will have to change.

The investment sector looks at the stock of a company by taking the price of the stock and dividing it by its earnings. For example: Company A’s stock is selling for $100 and its earnings are $5 per share. If we take $100, the price of the stock, and divide it by the earnings per share, $5, we get the number 20. This means that Company A is selling for 20 times earnings.  In the investment sector, we call this number a “stocks multiple”, or a multiple of earnings.

The multiple can be fairly low for a utility company, where the earnings tend to be very stable and a high percentage of the earnings are paid out in dividends. On the other hand, a growing technology company can have a very high multiple and use most of its earnings to grow the business, instead of paying dividends. While the price earnings multiple is not all that useful for short-term indications, it can be a guide to the future direction of the stock market.

To view the overall market, we will often look at certain indexes. The S&P 500 is one example of an index that is used for this purpose. Because it represents a portfolio of investments, it shows earnings for stocks at present.

For the past five quarters, the earnings of the companies that make up the S&P 500 have contracted (fallen). The perhaps erroneous idea that the second half of the year might be much better than the first half has helped the stock market. At this point, however, it appears rather likely that the earnings of the S&P 500 companies will contract again in the third quarter at about 2.1%. If earnings fall and stock prices stay the same, then the multiple on a stock will rise. If the earnings of Company A (from the example above), fell from $5 to $4 per share, then the earnings multiple would grow from 20 to 25, meaning that investors would be paying the same price, but for much lower earnings. The average multiple over the years for the S&P 500 stocks is 15.9%. Currently the multiple is 25.05. If stock prices stay the same and earnings drop further in the third quarter, then the multiple will increase further. In order to support the current earnings multiple of the S&P 500, we need more earnings. This does not appear to be happening.

Another way that earnings multiples get back in line with stock prices is for stock prices to drop. It seems to me, based on the current 25 times earnings multiple that an adjustment to 20 times earnings could occur. If this were to happen, we would be looking at stock prices falling by about 20%. In part, stock prices have been supported by extremely low interest rates. If rates increase on bonds, then both stock prices and bond prices could fall. More earnings would be the best solution!

Ed Mallon

October 12, 2016