Stocks are cheaper, coming off bubble warnings

Sometimes a 10 per cent drop in price can mean a discount that’s even bigger than that.

Stock prices have tumbled 10 per cent since the S&P 500 set its record high early this year, hurt by worries about interest rates, inflation and conflict in Ukraine. But based on measures that Wall Street uses to gauge stocks, they look perhaps 15 per cent cheaper, shaving off some of the concerns about an overly hot market.

At its core, a stock’s price depends on two things: how much cash a company will generate, and how much an investor is willing to pay for each dollar of that. To give a quick measure of the math, many professional investors look at a stock’s price against how much profit it’s producing.

One of the most popular such measures, which divides a stock’s price by how much profit the company earned in the prior 12 months, has dropped more than 15 per cent for the S&P 500 since its record high on January 3. A similar gauge, which looks at how much profit a company is forecast to earn over the ensuing 12 months, is down more than 12 per cent.

How can those valuation measures drop more than stock indexes did? It’s because profits are growing strongly, and analysts expect them to go higher.

Most companies in the S&P 500 have finished telling investors how much they earned during the last three months of 2020, and they’re on track to report growth of better than 30 per cent from a year earlier. Analysts are forecasting further growth of nearly nine per cent across 2022, according to FactSet.

And that’s why the S&P 500’s valuation is back to where it was in the summer of 2020, shortly after the collapse caused by the pandemic.

Of course, cheaper doesn’t necessarily mean cheap, particularly when it comes to a stock market that critics were saying was in a dangerous bubble.

The S&P 500 still looks more expensive than its historical average, based on various measures. Looking at stock prices relative to past earnings, for example, the S&P 500 is still close to 20 per cent more expensive than it’s been on average over the last two decades, even after its recent discount.

Few, if any voices on Wall Street are saying stocks are at screaming-cheap levels, like they were after the 2008-09 financial crisis, or maybe after the 2020 sell-off caused by the coronavirus. But many suggest the valuations look digestible, given how low interest rates are, even with expectations for the Federal Reserve to begin hiking soon.

AP