A Mental Model For The Stock Market

Stock market model

A few weeks ago, Factset published their latest estimate of the S&P 500 forward price-to-earnings (P/E) multiple:

S&P 500 Forward PE

For those not familiar with index-level P/E ratios, they basically work the same way as a single stock P/E ratio would.

That is, you start with the overall index level, which was 3,930 that day.  You then divide it by the next twelve months’ earnings forecast for all the S&P 500 constituents.

In aggregate, analysts are expecting the companies in the S&P 500 to deliver about $236 of earnings over the next year (note: in order to ensure comparability, this earnings figure is weighted in the same way the index is).

So you divide 3,930 by $236 and voila – you get an earnings multiple of about 16.6x you see in the chart above.

With the maths out of the way, a quick look at the chart above suggests two immediate observations:

The first one is that the P/E ratio has been steadily trending upwards over the past decade or so.

The second one is that it took a ~20% market drawdown to bring the current P/E ratio back in line with its long-term average of 16.5x.

Which naturally begs the question – is this finally a good time to buy?

A Matter Of Math

There are many different reasons why a P/E ratio might go up or down, but interest rates play a very significant role here.

The fundamental premise of finance is that “a dollar today is worth more than a dollar tomorrow”.

In periods of extreme inflation, a dollar tomorrow is worthless.  You should just grab your money and use them to buy something, ASAP.

But in periods of very low inflation and interest rates, a dollar tomorrow is nearly as valuable as a dollar today – and similar logic applies for a dollar a year / five years / ten years from today.

When interest rates started declining post the GFC, tech companies have been the key beneficiaries.

Given their outsized growth prospects, investors cared less about the profitability profile today – and put a lot of value on future earnings.

This is exactly how Tesla became a $50bn company by 2019 even though it was still losing money at that time.

Ditto for moonshots like Rivian, which was valued at $100bn despite only having a million or so in revenue.

As the tech companies became more valuable, so did their weight in the S&P 500 index.  At one point last year, the FAANG stocks made up 25% of it – and that’s how we ended up with the S&P 500 trading at 22x forward P/E.

What Goes Up…

With 8%+ inflation prints, we are in a different world.

Investors are no longer assigning as much value to all those future earnings.  As a result, tech is getting crushed – and taking the S&P 500 down with it.

When you are asking yourself “Is this a good time to buy?”, a big part of the answer depends on what you think will happen to inflation.

If you think it’s a temporary blip, you might take a bullish view – with the thesis that the Fed will get things back under control, interest rates will decline again, and asset values will increase.

On the contrary, if you think inflation will persist (or increase) that probably means more bad news as far as the stock market is concerned.  In other words, we’re not out of the woods just yet.

Sadly, that’s just one part of the answer…

The Big Unknown

So far, we have been focused on the multiplier which you apply to the underlying earnings.

But what about the earnings themselves?  What happens to the $236 of aggregate earnings per share that all those S&P 500 constituents are expected to deliver over the next 12 months?

Well, this is where things get tricky.

The earnings forecast is a bottoms-up figure prepared and collated by the army of research analysts who spend their lives following and valuing all the companies that value the S&P 500.

At its heart, it’s a lagging indicator – because there’s always a few degrees of separation between the analysts and the underlying operations of the companies they cover.

Right now, the big question mark everyone is trying to wrap their heads around is the upcoming recession.

Will it actually happen?  If it does, how long and severe will it be?  And what would be the impact on company earnings?

For all we know, that $236 of earnings might be a conservative figure.  We could possibly avoid a recession altogether; companies will blow it out of the park and deliver aggregate earnings well north of estimates – let’s say $275.

In that scenario, we will look back and say – “Ah, what a bargain it was!  We could buy the S&P 500 at just 14.3x P/E (3,930 divided by $275)”

There’s also the alternate scenario where the economy nosedives, the earnings drop to $200 and the actual P/E multiple is 19.6x – not that much cheaper versus last year.

And if that’s not enough uncertainty for you, then consider the fact that a rise in inflation can actually increase the likelihood of a recession.

All of a sudden, you’ve got a self-reinforcing feedback loop that throws all predictions out of the window.

This is exactly why predicting the markets is pretty much impossible.  There are just too many interconnected variables that evolve on a real-time basis.

Anyone who claims to know what will happen next is either lying or trying to sell you something (more often than not it’s both at the same time).

The reason I wrote this post isn’t that I think you can somehow control or predict the stock market’s movements.

It’s that as a long-term equity investor, you simply need to understand what’s going on – because it really helps you stay the course, especially during periods of elevated stock market volatility.

Think about it this way – let’s say you really have to go from point A to point B, but the only ride available is on a bumpy road and the car has no seatbelt.

Would you rather be bundled up in the trunk or in the passenger seat looking through the window?

The latter is still bumpy and uncomfortable as hell – but at least you know what’s going on.

Investing is the same.  If you want to reach your financial independence destination, you only have one choice – to put your money to work regardless of how volatile or unpredictable the markets are.

To extend the analogy above – it’s a choice between getting in the car or standing on the sidewalk.

Even if the road ahead is bumpy, you’ll still end up much further ahead of where you have started.

As always, thank you for reading – and happy investing!

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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.

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3 thoughts on “A Mental Model For The Stock Market”

  1. Thanks for this summary … finally managed to understand how the forward p\e ratios work. No crystal ball but I suspect analysts were a little too optimistic in H1 and we likely see the earnings bought down for the rest of the year.

    Will continue with my DCA strategy and continue to avoid the noise

    1. Banker On FIRE

      I agree with you. Would be shocked if there isn’t some kind of softness in earnings

      And yes, can’t beat a DCA strategy in the current environment (or any other for that matter)

  2. Pingback: Weekend reading: Mo' money, mo' problems - Monevator

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