In the last two posts, I examined the fundamental basis for earnings of the US stock market. In this post, I will look at pricing and to what extent the market is discounting any of the risks highlighted.
Given that we have been looking at earnings already, all we need to get to the index price is to multiply by the Price-Earnings (PE) ratio from the chart below.
It is clear from the chart that PE ratios have been rising as confidence in the durability of profit growth has cemented. The current pricing levels are such, that even if earnings do return to record levels in late 2021, we would still have a PE ratio at the highs of the last decade.
This suggests that far from pricing any risk that NIPA data might be correct, or that the earnings drop might resemble previous recessions, the market is currently fully pricing a return to record profitability and excellent growth in profitability to continue from there.
I would rate stock market optimism as extremely high.
One thought on “Has the US stock market disconnected from the real economy? Part 3”
Do you not think that such high PE ratios are a consequence of ZIRP?
Such low (nominal) interest rates have effectively destroyed the time value of money. Hence, growth stocks are now being valued ~5 years into the future. This has produced ‘high’ PE ratios.
Obviously, if CB’s raise rates, the story will be different, but without a serious bout of inflation, such action is unlikely. Thus, at present, such valuations may not seems too unnatural.
It could be worth creating a model of PE ratios adjusted for real interest rates & QE to get a sense of just how over/fairly valued stocks are.