Wild intraday market swings show how vulnerable stocks are to shifting investor moods. On Nov. 19, for example, the Dow Jones Industrial Average DJIA tumbled more than 400 points soon after the open, yet by afternoon the Dow was basically unchanged. Fundamentals can’t explain such a dizzying swing, but investors’ fickle emotions do.
A bull market rooted in earnings is far more solid than one riding on investors’ moods. The current market looks more mood-driven, and that puts the bulls on shaky ground. Fact is, if the S&P 500 SPX over the past five years had risen at the same pace as earnings per share, the benchmark index would be below 4,500 — about 25% lower. The reason the S&P 500 is above 5,900 instead is that its price/earnings ratio has widened considerably over the past five years.
Whether company earnings or investor sentiment powers the market depends in part on the time frame over which an analysis is conducted. David Rosenberg, the founder and president of Rosenberg Research, calculated the relative roles of earnings and sentiment over a one-year horizon. “We have a situation in the United States where the stock market’s up 41 per cent over the past year and earnings are up four per cent,” he told Bloomberg. Without the past year’s expansion of earnings multiples, the S&P 500 would be around 4,600, Rosenberg said.
Another source of ambiguity when examining the bull market’s gains is the choice of how to define earnings. You could focus on trailing 12 months earnings, for example, as Rosenberg does, or forward 12 months, or (as in the case of the Cyclically Adjusted Price/Earnings ratio (CAPE) championed by Yale University’s Robert Shiller) trailing 10 years’ inflation-adjusted earnings.
Regardless of the approach, the conclusions are largely the same, as you can see from the chart below: widening P/E multiples have played a large role in the recent bull market.
The stock market’s vulnerability is actually even greater, because the typical pattern is for earnings multiples to fall when interest rates rise, and vice versa. Yet the 10-year U.S. Treasury BX:TMUBMUSD10Y yield today is more than twice where it stood five years ago.
