Stock Prices

Sam Ngooi Comments

In our August Comments, we presented several investment definitions and principles that we consider useful in further understanding price changes in the financial markets. Interestingly, the price earnings (P/E) ratios we discussed in August have become a talking point in September’s media coverage of the volatility. Briefly put, some number of market analysts and financial media believe that stock prices have increased too much since their March 2020 lows, given the substantial increase of trailing P/E ratios (into the mid 30’s) for individual stocks such as Apple, Microsoft, Google/Alphabet, Facebook, and Amazon. The P/E of the S&P 500 index itself has also increased substantially, to almost 30.  And it’s become very difficult to make reasonable analysis of corporate earnings (the “E” in P/E), either trailing or projected, in the midst of the harsh economic effects of the coronavirus.

To review our August P/E discussion:  Stock prices change every day, based on the activity of buyers and sellers in the financial markets. Some of these market participants are long-term investors, looking to benefit from favorable long-term economic growth. Others are short-term traders and speculators, looking to make money over very short time periods, similar to gambling, regardless of whether prices are rising or falling.  From our August Comments: ”There are many factors that affect stock prices, but over time the most significant one is the profits (also referred to as ‘earnings’) of the company and the number of shares outstanding that have ownership of those profits. The relationship of one company’s stock price to that of another company, and the reasonableness of the stock price itself, can be examined by knowing the dollar amount of profits, and the number of shares the company has outstanding, and using these figures to develop the P/E ratio (price per share divided by earning per share).“

In the current stock pricing environment, for example, Apple’s price after its recent 4-1 stock split is lower than many other supercharged stocks. But Apple has the highest market value, at approximately $2 trillion, because it has so many shares outstanding and so much earnings to attribute to each share. Knowing the market price of a stock does not provide much useful information unless that price is coupled with the company’s dollar earnings, number of shares outstanding, and resulting earnings per share.  With all of that information, a P/E can be developed, which allows for fair comparisons and valuations of one company’s stock price to another.  The P/E of the S&P 500 index is developed in the same way, with the added complexity of calculating valuations for all 500 companies in the index.

Other factors that have been cited to explain either near-term gains or declines:

Very low interest rates for bonds. Again, from our August Comments: “When interest rates are low for bonds, as they are now, stock prices often move higher because the competing returns from bonds are low. But how high stock prices should go is of course an unknown, especially in times when the overall economy is doing so poorly, as it is now.”

Aggressive speculation. This speculation is often the work of short-term traders unconcerned with stock valuations. It also arises from trading options on individual stocks or the stock market, resulting in gains or declines, often within the same day. “In a market where buy and hold investors collide in a mosh pit with hedge funds, lightning quick computers, and now an army of new traders just learning the game, there’s room for debate about who’s moving prices. Also true of the market’s newest obsession: the role of equity options” (Bloomberg Business Week, 9/21/20, page 26).

Economic news. The latest economic news continues to be largely grim, as the coronavirus lingers on. This bad news has been in place for a number of months, so it is unlikely, on its own, to explain the September declines.

Lack of additional financial stimulus. Inaction by the federal government may have made the economic slowdown slower.  One reason for advocating less money to a new stimulus plan is to keep future budget deficits under better control, to reduce the likelihood of significant increases in inflation.  This factor, and the possibility that some stimulus could be added to the economy currently, appears to be driving significant day-to-day price fluctuations.  We would also note that however the stimulus issue is resolved, it can be a plus or minus for stock prices over time.

Notice also that index results year to date vary considerably, as the NASDAQ, dominated by the high-flying tech stocks with high P/Es, continues to massively outperform the modest gain for the S&P 500 stocks, the modest declines for the Dow Industrials (30 stocks), and the larger declines for International and Emerging Market indexes.  Whether that indicates that tech stocks have much room to decline, or the other stocks have much room to advance, is yet another unknown that will be played out over time.

Political uncertainty. Our final section on factors potentially influencing stock prices brings us back to our discussion of the upcoming election. The first presidential debate (August 29th) was overshadowed by the October 2nd news that President Trump, along with a number of his close advisors, had contracted the coronavirus. As of this writing, the president seemed on his way to recovery, but no matter what we hear about the prognosis, the medical event seemed to add even more uncertainty to a highly contentious election. As our regular readers know, and as we wrote in our August 2020 Comments, “we at PPA maintain that who is president is only one of several factors affecting stock and bond prices. Even if we know who is going to be president, no one can predict what will happen during that presidency.  Trump’s presidency is a perfect example (see July Comments). Even now, with Biden leading in the polls, stock prices have been rising for most of the past few months” (although not in September).

We will continue to comment on the election as the time gets closer, as it is likely to become a popular topic in the media. But we repeat that in our view, there is nothing inherently predictive about the connection between market prices and election results, certainly not as time passes and other intervening events become more important.

Our advice remains the same: maintain asset allocations developed for your circumstances for the long-term, and rebalance from time to time based on significant changes in market prices, which means selling the better performing asset class and buying the weaker performer in a given time frame.