Good morning and happy Monday!
“There’s no such thing as a worry-free investment. The trick is to separate the valid worries from the idle worries, and then check the worries against the facts.”
– Peter Lynch, legendary investor
The stock market goes up, the stock market goes down. This has been the story since the beginning of the stock market and will continue to be the story for as long as the stock market exists.
But what actually causes these fluctuations?
Today I will try to scratch the surface and hopefully explain a little bit of the “why” behind some of these market movements.
I’m going to warn you in advance, I just have a feeling this might be a bit longer than my normal emails, but hopefully it’s helpful in putting some pieces together.
Take a look at this chart from 1996 – September 2023 (also attached):
I shared this same chart a few weeks ago, but I would like to take a bit of a deeper dive here to hopefully make sense out of some of this stuff.
I would like to draw your attention to the “P/E Ratio (fwd.)” That references the future Price-to-Earnings ratio … arguably the most important investment component that exists. This refers to how much investors are willing to pay to take an ownership stake in a company.
Lots of media attention and water cooler conversations revolve around stock price: “Did you see that ABC stock is trading at $5/share?” “I was able to buy XYZ stock for $10 per share.”
Stock price obviously matters, but only in context.
If Intentional Wealth were a publicly traded company (which it is not) then what would the stock price be? That all depends on how many shares are issued.
Let’s just say the company is worth $1,000,000, if there are 1,000,000 shares issued then the stock price would be $1 per share. If there were only 10 shares issued, then they would be worth $100,000 each.
What matters far more than stock price is company value. If the stock is a $1 per share or $100,000 per share it’s the same underlying $1,000,000 business value, stock price just references matter of how many pieces that company value is broken into.
Side note: if you see a company do a stock split people get super excited, but that does absolutely nothing to change the value of the company. If a stock is $100 per share and does a 2-for-1 stock split you now own twice the number of shares but at half the value ($50 instead of $100).
P/E ratio is one of the major factors that investors are looking at to determine what a company is worth.
The forward P/E in the above chart refers to the forward price-to-earnings ratio of the companies in the S&P 500. On January 3, 2022 it was 21.4x, by October 12, 2022 it was 15.7x, and it sits at 17.8x as of September 30, 2023.
So, what does that mean and why does it matter?
On January 3, 2022 I would have to pay 21.4 times the annual projected forward profit in order to acquire an ownership stake. That means that if a company’s forward projected profits are $1,000,000 a year, then I would have to pay $21.4 million ($1,000,000 x 21.4) in January 2022 to purchase that business.
By October 12, 2022 that value had reduced to 15.7 times. That means I could purchase that same business for $15.7 million ($1,000,000 x 15.7) … a significant discount. Lower share price, yes … but lower P/E ratio is more what investors want.
Stocks are just like shopping … as a buyer which would I prefer: to buy at an expensive price or a cheap price? Of course, I want the cheapest price possible, the lower the P/E ratio gets the more excited I get as a buyer.
Alternatively, a seller is always going to want to sell for the highest price possible. The price that is settled upon is where buyers and sellers meet.
If a can of soup costs $100 at Publix tomorrow, then I will not buy a can of soup. The seller is asking too much, and I will not be a buyer.
If Publix runs a BOGO I may purchase items I would not plan on otherwise buying … I’m guilty of falling for this virtually every time I step foot into Publix. 😉 I do this because as a buyer I feel that I am getting a good deal.
The stock market kinda’ operates in a similar fashion. When a P/E ratio gets high (as it did in March 2000 when it hit 25.2) then investors basically say, “Holy cow, I can sell my ownership stake in this company for 25.1 years’ worth of profits … push the sell button.” This would be like Publix realizing that a ton of people buying a can of soup for $100 … they will sell as much soup as they can at that price. Sellers, be it Publix or investors, are going to sell when they see the price is at an attractive place.
When the P/E ratio gets super low, like it did in March 2009 when the P/E ratio was 10.4, then buyers swoop in. How could they not? “Holy cow, I can buy businesses for only 10.4 times the annual forward profits … that’s a heck of a deal, buy, buy, buy” and they pull out their checkbook to make the purchase. These buyers were able to buy for a fraction of the price that had previously been available. It’s like the stock market is on sale so buyers jump in. Soup is BOGO so I buy 20 cans 😉
Intellectually this makes total sense: buy low and sell high. But we are human beings with emotions, not robots. When the market is super expensive from a P/E ratio that means the stock market is probably hanging around all-time highs … it’s tough to convince ourselves that it’s actually a good time to sell. It’s even harder to pull the trigger to buy when stocks are cheap because what would have caused them to be cheap is a sharp market downturn.
You will see as of September 30, 2023 the forward P/E ratio was 17.8. That means that stocks are roughly 17% cheaper on a price-to-earnings basis (17.8 P/E vs 21.4 P/E) than they were on January 3, 2022 when the market hit its current all-time high. What’s interesting here is that the S&P 500 value is down roughly 10.6% from that all time high but the discount on a P/E ratio basis is more significant.
Ok, so I just bombarded you with a lot there … what are we to do with all this information?
If you are buyer: be excited, stocks are cheaper than they had been and this likely is a very attractive time to make additional purchases. Keep buying, purchases today get greater ownership in companies for the same amount of investment.
If you are a seller: be patient, these values fluctuate and history shows that higher values are likely to come and better times for sellers are ahead. Selling now means your losses have been realized, waiting to sell means we have an opportunity to recover these losses. Minimize what you sell when values are lower.
Bottom line: these types of market fluctuations are normal, natural, and healthy. Stick to the plan. Ignore the hype. Keep your cool.
It is a tremendous honor to serve you. Please reach out with any questions or ways my team and I can provide any assistance.
Make it a great week ahead! 😊