How Much Will P/E Ratios Dampen Markets in 2020?

Price to Earings Ratio

If you believe that price to earnings ratios are a big constraint on stock prices, you probably don’t expect much from stocks in 2020. This wall is only made of paper though.

People are only calling for a very modest year for stocks next year, only expecting single-digit gains, and it’s actually pretty amazing that we’d find this much consistency with a task that is so difficult and should normally provide a wide variance.

When we look at what is constraining these predictions, after a simply great year with so much momentum going for us as it winds down, it turns out that the biggest reason is concerns about our pushing price to earnings ratios, or P/E ratios, much beyond current levels.

From this perspective, there are two ways that stocks can rise in value, and it’s by seeing earnings expand and seeing P/E ratios expand. Earnings are not expected to grow by that much next year, and P/E surely is extended, in their minds at least, so this has us pretty much down to relying on these modest earnings increases to see stock prices go up.

The following of the P/E understanding of stock prices, believing that this fundamentally shapes them and not the other way around, is much more like a religion than real knowledge, where we are told that we are to believe certain things and we are not to question these beliefs very much. If we are going to be using these beliefs to shape how we invest, they cannot remain unquestioned though.

It is commonplace for people to substantially rely on this creed when sharing their beliefs about the outlook of stocks, and there are plenty of occasions where we need to seek to provide more clarity, even though these beliefs run so deep that hardly anyone else even questions them very much. If we wish to have P/E concerns provide us with pause or even to use them as a basis for caution, we at least need to take a good look at whatever validity these beliefs may have and just not assume it.

We need to start with asking what role earnings really have in stock prices in the aggregate. We cannot deny the fact that current earnings do shape people’s outlook, although all we have to do is look at how P/E ratios change over time to see how weak and useless this correlation is.

This is supposed to represent a wall of some durability, if we’re using it to limit such a strong market and actually believe that it will as so many do for 2020, but as it turns out, it is not so durable and is more like a moving average, where the line itself doesn’t exert any intrinsic pressure on what it is measuring, it rather just measures it.

We are measuring degrees of positivity on the outlook of stock prices with this, and nothing more. We may see this positivity sustained or wane, but it is the beliefs themselves that shape this and not some arbitrary number that will summon forces outside reality to rein us in.

This is a very important point and itself can make this whole task a lot more transparent, and what is being measured by it has nothing to do with earnings at all, as they are just being used as a reference point to measure the mood of the market.

P/E Ratios Only Serve to Measure Market Sentiment

P/E ratios actually provide a very good benchmark to measure sentiment, as it looks to determine how much mood is contributing to stock prices independent of changes in earnings.

We could portray this mood as subjective, but not purely so as it actually is based upon on how we feel about the prospects of the price of stocks increasing in the future, where if we feel better about the future we will pay for stocks and vice versa. This has its subjective component to be sure, but also relies on data, data that looks beyond 2019 or even 2020 and into the years ahead, the ones that investors look to when they invest, as well as on recent performance.

It may seem that this should be pretty obvious to us, but for whatever reason, the vast majority of people are so focused on the present and the near term that they completely miss the fact that stock prices do not represent present value or near-term value but longer-term value. If we miss this, we will really lose our way, as we will be bent on discounting this future value that the market is pricing in and just end up lost and confused.

Using earnings as a fundamental reference point for stock prices is another big mistake that we make, and the wide variation in P/E ratios that we see make this plain. People do not invest in common stocks for earnings, they buy stocks in the hope that their prices will go up over time and achieve good returns from this. Earnings do matter to a certain degree, as better earnings look good on balance sheets and this may entice people to invest in the companies more, but this still is completely artificial and we need to understand this.

A stock like Tesla provides us a good glimpse of all this in action, and we could just keep bidding up this stock forever if we wanted for an unlimited number of losing years, provided that they can stay solvent that is. When one of the hottest stocks right now has negative earnings, this should serve to wake us up to the fact that this really isn’t about how much money a company is making right now or how much they may make next year, it’s about future valuation.

People are getting excited about this stock a lot more lately and the hope is that one day this company will be making a lot of money, and they want to get in on the lower floors of what they see to be a very good investment from a fundamental perspective one day. Fundamentals do play a role in stocks, but not so much in the way that we think, when we look at the ground when we should be casting our vision on the horizon instead.

When we do so, we can easily see how present earnings are not only not the sole voice that is speaking, as here is a louder one, the voice of future expectations of earnings, and this takes us well beyond the timeframe that we’re looking to make our predictions in, 2020 in this case. Limiting our outlook to what is right in front of our faces and then assuming that the market will do the same thing may be a good idea if the market had the same beliefs and mechanisms of pricing, but they clearly do not and we’re just choosing a very distorted path for no other reason than this is part of our mistaken creed.

P/E ratios can also go up when earnings decline, but we don’t want to necessarily use this as a limiting factor either, and in fact this is where we see these limitations really restrict us. Since this is just a measure of what we are calling the market’s mood, when earnings get pared a lot, from an economic slowdown for instance, the very high P/E ratios do not indicate that stocks are this overpriced, it instead favorably compares future earnings to present ones.

They are certainly overpriced in reference to present conditions in this case, but once again, stock prices look much further out than this, and as they go higher, this portrays a level of confidence in the future, as P/E ratios serve to do generally. That’s all they do in fact. This is telling us that the market feels that earnings will catch up and things will be fine, which is hardly a reason in itself to flee.

There is actually no such thing as overpriced or underpriced, at least as far as the long run is concerned, even though on shorter-term timeframes stock prices continually bob between these two perceived conditions. It is the perceptions of this, together with our acting in concert for various periods, that actually drive these moves though. Stocks trade in trends, and these trends do extend beyond the current equilibrium and become corrected by the reversal, but this has nothing to do with either P/E ratios or even investing, given that its focus will just smooth this over as we seek our long-term returns and ride the upward wave on this scale.

Fundamentals Never Limit Stock Prices Unless We Want Them To

Thinking that it would even be possible for a stock to be fundamentally overpriced or underpriced completely misunderstands the causation of stock prices, as whatever prices emerge are always a complete and accurate valuation of a stock’s price at the time, with not even any room for discussion. Stock prices are completely factual and never normative no matter how much we wish to believe that they are.

Variations in external factors may or may not change things, but changes in the internalization of all this by the market does so directly, as the market is the place where all information is processed and its output is the sum of all this and the absolute bottom line. While we do see the potential for these valuations to change, this is not because today’s value isn’t accurate, it is because these values do change in the future, and there is a big difference here.

We can value the S&P 500 at a certain level today, but we stay invested in it because we expect this value to expand over time, and the only thing that drives this is the expectation that people will pay for it in the future at a time we wish to sell our shares. This expectation is self-perpetuating, and will always trump everything else, such that if we hold beliefs that outside forces compel it, even if we are right, the market will always filter it along with everything else it is considering and it’s mood and direction aren’t just the most important things in the end, they are the only things.

We’re hearing comments such as stocks going up all that much in 2020 would extend the P/E curtain further out, and given that they don’t think that is appropriate, they are calling for this to not happen. While it is true that these ratios can and do provide a psychological barrier to price growth at times, and stock prices are completely about perception, it is not that we want to just ignore these concerns, but we do want to look at how these concerns may affect things overall, when we add in whatever positive influences may be present.

Understanding that P/E is really all about market psychology would substantially expand our understanding of these forces, and again, this should be fairly obvious if not for our clinging to our beliefs that this is all somehow determined by present economic forces. We expect P/E ratios to themselves act as an objective limiting factor, and don’t understand just how subjective this all really is.

If we instead see this as what it actually is, a benchmark for market sentiment, then we become open to the idea that sentiment may continue to expand, and see P/E for what it really is, just an indicator that provides us with what can be useful information if we listen closely.

When we look at the P/E for the benchmark S&P 500 index, we will see that we’ve almost climbed back to 2017 levels of 24.97. We’re coming in at 24.27 this year, an improvement over the 19.6 that we got in 2018, where we allowed concerns about the Fed to put a dent in our mood, which has since been resolved and have allowed us to get back on track.

This deficit between 2017 and 2018 did provide us with more room, and if we go back in time to a year ago, when we got happier about the prospects of interest rates not going up more, and consider this deficit representing a measure of the damage that occurred when it became subdued, looking at P/E can actually add some real insight, provided we use it correctly that is, as it would indicate unusual upside potential in this case.

We could have actually quantified this pretty well by taking earnings projections and then adding in the effect of P/E returning to the previous level and would have had an impressively accurate idea of how 2019 would unfold. We don’t often have such a clear opportunity to predict the future, and there are of course a number of intervening factors that could have taken us off course, but this at least would have allowed us to have a very good idea of where we would be headed provided that nothing that meaningful happened to upset the market and restrain P/E.

P/E ratios can also be used this way to measure the mood toward individual stocks, even though this is a far cry from how people actually use them with stocks, where they are instead seen as false limiting factors. We instead use the terms overpriced and underpriced, where we should be seeing these numbers instead as indicating degrees of favor or disfavor.

In the end, it is this relative favor that sets the price and continues to do so, but by twisting our thinking enough to think that in favor is bad and out of favor as good, we surely will be heading down the garden path, as well travelled as this path may be.

This is the biggest mistake that fundamental analysts make by far, and this thinking still dominates the industry. You have to look no further than all the palms that are going up now when we consider the prospects of current market P/E levels expanding, even though they have expended by 50% during our current bear market and there is no good reason that we can’t continue this, as long as people are comfortable doing it. Whether they will be next year or not is more a matter of debate than is being recognized.

P/E concerns will definitely weigh in on 2020 results, but only to the extent that we wish them to. To the extent that we allow this to have us putting our foot on the brakes, it will. However, hardly anyone will be braking from these projections, and there wouldn’t be a good reason to anyway, because if everyone’s predictions come true and we really do only get single digit gains next year, that’s no reason to brake at all.

This will likely allow for the current positive outlook on stock prices to continue to be expressed, resulting in the prospects of another double-digit year becoming quite plausible in itself. If not for the potential concerns surrounding the election, we could even see it as probable pretty easily. This is a real potential limiting factor, unlike the P/E concerns, and it pays to keep our eyes on the real tigers and not be distracted by paper ones.

For most, this is all just an academic exercise, as we will be choosing to stay the course whether we get single or double-digit returns next year, but sometimes academic exercises can be informative, provided that we are open to actually learning.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: andrew@marketreview.com

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