- This fallout—while new and uncomfortable—represents a tiny part of the market’s forward-looking focus.
- Sharp selloffs provide an opportunity to own investments at inexpensive levels under historical conditions that should inspire confidence.
What do stock-market prices tell us? Lately, they’ve been telling us that investors are afraid. They also suggest that stocks are beginning to look like a bargain.
Putting a Price on Stocks: What’s it Worth Today?
Academics characterize stock markets as forward-looking discounting mechanisms. More simply stated, this means that, as a collective group, investors use all available information about the future in an effort to put a value on a company.
This exercise—in which forward-looking expectations produce a current price—is known as discounted earnings analysis. It’s based on the idea that we can determine the current value of a future payment or income stream by “discounting” it backward through time at a pre-determined rate. Scaled up from individual companies to the market level, pricing should reflect all available information about the future earnings potential of the market, serving as a partial proxy for the economy.
Rapid Repricing Resembles Panic
Armed with this understanding of how new information gets factored into prices, we can sympathize with the challenge presented by a quickly evolving (or deteriorating) environment. The onslaught of developments presented by COVID-19’s spread and a simultaneous collapse in oil prices has forced financial markets to recalibrate prices sharply as expectations about different industries and the overall economy shift at a breakneck pace.
What’s it Worth in the Future?
One way to think about the market’s forward-looking focus is with well-known metrics like the price-to-earnings (P/E) or price-to-book (P/B) ratios. The S&P 500 Index had a forward P/E ratio of about 15 on March 25, 2020, meaning that investors must pay a price equal to 15 times the estimated annual earnings of its constituent companies to buy them. That’s the next 60 quarters of earnings.
There’s some reassurance in the fact that a COVID-19-containment-induced earnings recession is generally only expected to last a couple quarters or so. If market prices are based on the next 60 quarters, then this fallout—while new and uncomfortable—represents a tiny part of the market’s forward-looking focus.
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Index returns are for illustrative purposes only and do not represent actual investment performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
This material is provided by SEI Investments Management Corporation (SIMC) for educational purposes only and is not meant to be investment advice. The reader should consult with his/her financial advisor for more information. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results