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Tackle Today: Of Profits & Total Return Sources

September 8, 2022

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«The P/E Ratio Lens.»


As of Aug 31st, the S&P 500 was down 13.3% year-to-date, and it’s worth exploring what’s driving the return from a P/E perspective. When you understand the price-to-earnings ratio and how it plays into market analysis, you discover the two reasons that stocks fall.

  1. First, they fall because investors lower how much their willing to pay for each dollar of earnings. The change in disposition is driven by pessimism about the future, and it’s known as multiple compression.
  2. Second, they fall because corporate profits are falling. If stocks perfectly tracked earnings in the short run, a 5% drop in earnings would deliver a 5% drop in stock prices.  

So what’s the cause so far this year? Cast your eyes on the chart below, and you’ll find the answer. Year-to-date earnings growth has been positive 5.6%. Meanwhile, we’ve seen multiple compression of negative 19%. Combining them arrives at the S&P 500’s 2022 return of 13.3%.

Takeaway one: the stock market hasn’t been falling because of deteriorating corporate profits. Indeed, if stocks followed earnings this year, the S&P 500 would be up!

Takeaway two: the stock market has been falling because of multiple compression. Inflation, higher interest rates, and the clear and present danger of a recession have soured sentiment. With that, traders are no longer willing to pay as much as they used to for each dollar of earnings. Entering the year, the S&P 500 was trading with a forward P/E ratio (aka multiple) of 21.4x. Now the multiple is 16.6x.

Video Of The Day: Jedi Options – Trading a Breakout on $CSIQ

In today’s Jedi Options, Coach Tyler explains his trade on a breakout on $CSIQ.

Chart of the Day: Sources of Total Return

Chart of the Day: Sources of Total Return (Source: J.P. Morgan Asset Management)
J.P. Morgan Asset Management

Earnings per share on the left. Percent chance in S&P 500, earnings, and valuation on the right.

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