Dear Reader,
Stock prices have been falling since the beginning of the year.
The S&P 500 is down 18% from its January 3, 2022, closing high of 4,796.
However, stock valuations — as measured by the forward price-to-earnings (P/E) ratio — have been falling since August 28, 2020.
For investors thinking about trading based on value, it's imperative to remember stock prices don't have to fall for valuations to fall.
This is especially the case when earnings are growing, and earnings have been trending higher for decades.
The mathematical nuance behind this is pretty basic and straightforward, but it may not be immediately intuitive for some.
The idea of falling valuations tends to have a negative connotation, so, understandably, you might default to thinking that prices should fall.
This is very relevant right now, especially with many experts arguing that stock market valuations should come down.
In the stock market, valuation can be loosely defined as the premium you pay for a company's earnings.
Whether a company is worth $100 million or $10 million doesn't tell you much. But if a $100 million company and a $10 million company are each earning $1 million a year, then the $100 million company is carrying a higher valuation than the $10 million company.
The simplest way of measuring value in the stock market is the price-to-earnings, or P/E, ratio.
The big picture here is that you can never rule out the possibility that economic conditions deteriorate significantly, bringing earnings and stock prices significantly lower.
But strictly from the perspective of valuations, it's important to remember that falling stock prices are not a condition of falling valuations.
The critical variable is earnings, which we know are the most important long-term driver of stock prices.
Data from Deutsche Bank shows earnings have been trending higher for 85 years.
In recent years, thanks to the COVID-19 pandemic, we've learned just how resilient and adaptable companies can be in their efforts to preserve earnings growth.
As long as earnings are expected to grow over time, you should expect stock prices to eventually follow.
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