WARNING:  If you tend to think like an engineer, you will probably find this interesting and useful. If you do not, well………………

There has been a lot of interest in negative articles floating about the interwebs lately, and some of the articles are suggesting that P/E ratios of stocks are too high! (And the premise is that would be an indicator of a softening market.) So, first recall that a P/E ratio is simply the price of a stock divided by it’s expected (!) future earnings. That makes many of these articles with similar content nothing but nonsense, in my opinion.

Think about how markets work. Prices will always reflect what is expected in the future. Put another way, the point of the markets is to create a mechanism where you can buy the future today…and at a discount!

SO: As earnings rise above expectations, so do Wall Street assumptions. Higher earnings will result in higher prices; that’s just simple math. But you have to keep in mind that the P/E ratio of the S&P 500 is based upon expected future earnings. As the real numbers are reported, assumptions are updated with the new facts. If the new facts look better than the prior assumptions, the S&P will necessarily move higher. Because, math. Therefore:

  • In a growing economy, the PE ratio will always look expensive.

That’s how the stock market works. Earnings are BLOWING AWAY (a technical term) ESTIMATES this quarter. We analyze earnings results and reactions each quarter at DSWP. I would like to share with you the total actual earnings vs. expected earnings each day for companies with market caps over $1 billion. Here’s the total for the first 9 days of earnings season this quarter:

  1. Tuesday, July 13th: $24.08 vs. $17.45, or a 37.99% beat
  2. Wednesday, July 14th: $18.88 vs. $14.91, or a 26.63% beat
  3. Thursday, July 15th: $24.17 vs. $20.74, or a 16.54% beat
  4. Friday, July 16th: $6.65 vs. $6.65, or a 0.00% beat
  5. Monday, July 19th: $28.64 vs. $24.87, or a 15.16% beat
  6. Tuesday, July 20th: $51.32 vs. $41.96, or a 22.31% beat
  7. Wednesday, July 21st: $191.66 vs. $156.39, or a 22.55% beat
  8. Thursday, July 22nd: $139.66 vs. $119.61, or a 16.76% beat
  9. Friday, July 23rd: $17.05 vs. $16.67, or a 2.28% beat

So, it is apparent that earnings are consistently exceeding expectations. Many fundamentalists believe that PE ratios should be consistently in the 15 to 20 range, but that’s ridiculous. When interest rates are at or near historic lows and GDP is at or near historic highs, PE ratios deserve to be much, much higher than the norm. There are a number of factors that go into valuations, not the least of which are growth rates and interest rates. Investors are willing to pay up for earnings as alternative investments are yielding next to nothing. We will at some point, however, reach a situation in which valuations really are too high and our economy will therefore experience a downturn, resulting in deteriorating profits. In my opinion this is unlikely to happen this year. Note, however, that if the S&P rises too far too quickly, that could lead to a correction, possibly even a deep correction. But that’s fodder for future letters as we get closer to 2022.

Ron’s Market Minute – All is Not as it Seems

Market breadth is a measure of the health of a market. When the ‘index’ returns are driven more-or-less equally by all of the stocks in the index, breadth is said to be broad, and that indicates a healthy market. On the other hand, when the index returns are driven by a smaller handful of stock returns, that is a ‘narrow’ market, or breadth is narrow. This is generally a sign of higher risk, or a weaker market. See the chart. The lower chart shows the market returns this year EXCLUDING the five largest stocks – known by the slang acronym, ‘FAANG’.

The FAANGs are Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NGLX), and Alphabet (GOOGL). Two of the largest indices — the S&P 500 Index* and the Nasdaq Index* — are capitalization-weighted, which means the stocks with larger capitalizations have more representation in the index –, and that sets up the opportunity for distortions in market returns. 

The impact of the market returns with and without the five largest stocks is easily seen by comparing our two charts. The upper chart shows the current strong-looking uptrend in the S&P 500 Index. The lower chart is the average of the stocks of the S&P 500 Index without the FAANG stocks. Note that the lower chart looks rather a lot like the REST of the overall market which is currently range-bound; basically, going nowhere.

We’d like to see a rotation of leadership and a much broader market breadth. Those things could push markets higher, and markets would be ‘healthier’. Until that happens, the breadth likely will become narrower and narrower which will then increase market risk significantly, especially in the short term — as the bulk of returns are in only five stocks.  We see many investors chasing this small group of stocks.

When the inevitable pullback comes, and investors retreat from these key stocks, the pullback will likely pull down the returns of the indexes.  

 

Ronald P. Denk, CFP®
Investment Advisor
Denk Strategic Wealth Partners
10000 N. 31st Avenue, Suite C-262
Phoenix, AZ 85051
Phone (602) 252-8700
Fax (602) 252-8701
Toll-Free (877) The-Denk
www.denkinvest.com

LFS-3706037-080621

This weekly article reflects news, commentary, opinions, viewpoints, analyses and other information developed by Denk Strategic Wealth Partners for use with advisory clients only and/or select but unaffiliated third parties. DSWP provides Market Information for illustrative and informational purposes only. If you wish to receive this weekly commentary by email, please contact us at 602-252-8700 or by e-mail at lindaw@denkinvest.com. If you are receiving this commentary via email and would prefer not to please let us know either by email or phone.

Ronald Denk is an Advisory Representative offering services through Denk Strategic Wealth Partners, A Registered Investment Advisor. He is also a Registered Representative, offering investments through Lincoln Financial Securities Corporation, Member FINRA/SIPC.

Denk Strategic Wealth Partners is not affiliated with Lincoln Financial Securities Corporation. Information in this commentary is the sole opinion of Denk Strategic Wealth Partners. Past performance is no guarantee of future returns. All market related investments involve various types of risk, which include but are not restricted to, credit risk, interest rate risk, volatility, going concern risk, and market risk.

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*The indices are representative of domestic markets and include the average performance of groups of widely held common stocks. Individuals cannot invest directly in any index and unlike investments, indices do not incur management fees, charges, or expenses, therefore specific index returns will be higher. Past performance is not indicative of future results.

Ron Denk is a Registered Representative, offering investments through Lincoln Financial Securities Corporation, Member FINRA/SIPC.

Mr. Denk is also an Advisory Representative offering services through Denk Strategic Wealth Partners, a Registered Investment Advisor. Denk Strategic Wealth Partners is not affiliated with Lincoln Financial Securities Corporation.

Please see Denk Strategic Wealth Partners’ Client Relationship Summary here http://denkinvest.com/?page_id=7099 for succinct information about the relationships and services DSWP offers to retail investors, related fees and costs, specified conflicts of interest, standards of conduct, and disciplinary history, among other matters.

LFS’ Regulation Best Interest Disclosure Document, which describes LFS’ broker-dealer services, and other client disclosure documents can be found here <https://www.lfg.com/public/lincolnfinancialsecurities/clientinformation/overview/disclosure>.

Past performance is not a guarantee of future returns.