Did you know that there are only two ways that stock prices can move up from their current levels?
That’s right — despite what the mainstream media wants you to believe — the future value of the stocks in your portfolio is going to be affected by only two factors.
That’s because the market’s mechanism for pricing stocks is relatively straightforward and it’s expressed by this simple, yet powerful, equation:
Stock price = price-to-earnings ratio x corporate earnings
While the equation itself is simple, there are many complicating quantitative and emotional elements that influence the amount investors are willing to pay for stocks (the price-to-earnings ratio) and the financial performance of the companies (corporate earnings) being valued. But in the end, it’s just two variables that matter: P/E ratio and earnings.
|Don’t get distracted by the endless flow of information coming from the mainstream media.|
That’s why you shouldn’t get needlessly distracted by the endless flow of information coming from the mainstream media that is of little, if any, investment value.
After last year’s 30 percent plus increase in the stock market, price-to-earnings ratios currently stand at lofty levels. In fact, one popular measure, the Shiller P/E ratio, is once again approaching record highs. While it’s obviously possible for stock valuations to rise even further because P/Es are based as much on emotion as they are on empirical facts, there isn’t likely to be much help to stock prices from upward moves in P/E ratios.
That means it’s more likely that the next big advance will have to be fueled by corporate earnings growth.
And with approximately 70 percent of the U.S. economy based on individual consumption, it’s the consumer that’s going to have to drive any meaningful profit growth.
How is the consumer doing?
The short answer is not so great.
Because of the lack of real wage gains and real total income growth that I’ve pointed out in previous Money and Markets columns, the only way consumers can increase their purchases of goods and services is to reduce their already low savings rate or increase their high debt levels. While consumer confidence has stabilized after it plummeted during the financial crisis, it remains well below its pre-recession peak.
What’s more, household debt remains elevated even though, as a percentage of disposable personal income, it has fallen from a peak of 130 percent in 2007 to 104 percent in the third quarter of 2013. But it’s still well above its 65 percent norm! The most recent data is presented in the chart below.
Considering the memories many households still have of the horrors of excess debt, consumers are retrenching, with retail sales declines in December and January and slightly up in February. That’s much to the dismay of retailers who appear to be stuck with excess merchandise, as reflected in their rising inventory-sales ratio.
All of this data has the Federal Reserve pinning its hopes for a dramatic increase in consumer spending on something called the Wealth Effect. Former Fed Chair Ben Bernanke explained that the Wealth Effect occurs when “higher stock prices boost consumer confidence, which can spur spending.”
So far, there’s been little evidence to support the notion that a Wealth Effect actually exists except for an experimental concept in the imagination of certain Fed members. Next week, we’ll look closer at the theory behind the Wealth Effect and you can decide for yourself whether you think it’s real or imagined.
For now, investors should keep a close eye on corporate earnings reports as we are headed into the heart of the earnings season this week. It will be a reality check on the overall health of the economy and where your portfolio will go. That’s because without earnings growth, the stock market will struggle to make any upward progress.