During the recent market turmoil a client posed the question, if the economy is less than 30% likely to fall into a recession again in the near term, why has the market sold off so much so quickly? The answer is a constricting market multiple (fancy wording for fear). Wall Street rarely likes to use only one name for the same indicator, so “market multiple” is another name for the price/earnings ratio (P/E) for the entire stock market. A P/E ratio is derived by dividing a stock’s share price by its earnings per share. In other words, this ratio is the number multiplied to earnings to get a stock’s price. Higher multiples show a belief by investors that the stock (or index) is due to increase earnings. A lower multiple shows fear that the stock’s earnings could shrink.
An index’s multiple is essentially a reading of investors’ fear or exuberance. The fundamentals behind an index do not change as often as sentiment does and that is what causes prices to fluctuate. During the recent correction few companies reduced earnings forecasts, but fear took hold of the markets and showed up in lower stock prices and thus a lower market multiple. Fundamental analysts are able to qualify why their predictions may not come true and try to save face by referring to this fear as a tangible number. They are able to show that their earnings predictions were accurate, but the pesky constricting market multiple is the cause for their lack of accuracy. Bearish analysts use the same excuse when fear subsides, multiples expand and stock prices rise before their ratings change. Contracting multiples are a symptom of fear, not a cause.
Value investors like to buy stocks with low multiples in the hopes these stocks are being viewed with too much negative influence and should rise in price or at least have limited downside risk. Growth investors tend to give current P/E ratios less weight in their analysis as they bet earnings will grow enough to make the expanding multiples more reasonable in the future. Technical analysts disregard emotional input such as expanding and contracting multiples and focus on staying ahead of major price moves (in both directions) based on price analysis where the early signs of emotional shifts can be found.
Fundamental and technical analysis do not have to be mutually exclusive in an investor’s decision making process. Combining the two can create returns that beat major index returns. AF Capital Management combines both approaches to determine entry and exit prices for stocks and ETFs in our managed clients’ accounts. ”Do It Yourself” investors can subscribe to our Market Timing Service for buy, neutral and sell ratings based on technical analysis on 15 index and sector ETFs. Investors interested in finding help with understanding the fundamentals and creating a proper asset allocation for your personal situation should consider opening a managed account.