The stock market is a complex organism with many factors constantly influencing its movement. Sentiment plays a large role in assigning valuations at least in the short-term as much as more fundamental inputs such as earnings, cash flows, and interest rates. We are currently in a pessimistic environment which has drastically affected valuations.
How Does Sentiment Play a Role?
Quite simply, sentiment directly affects how much investors will pay for a certain stock. For example, Intel could have earnings per share of $2.00 in two completely different market environments and the stock price would be miles apart in each market. In the late 1990’s the stock routinely traded for over 30x earnings. Now it is changing hands at a measly 9x earnings. The difference: market sentiment.
Nowadays, investors are extremely cautious and are demanding more for the amount of risk they are willing to take. In other words, the risk premium on the market is high which has the affect of pushing valuations ever lower. This is a double whammy when earnings estimates are being cut which is usually the case in a recessionary environment. So not only do earnings estimates drop which is the “E” in P/E, but so does the price that investors are willing to pay for those earnings.
Reason for Optimism
I believe the market has excellent long-term value precisely due to the opposite of what is mentioned above. Once the economy starts improving and earnings estimates start to creep up, investors will begin to regain what John Maynard Keynes called “animal spirits.” Market players will feel more confident about the market and be willing to pay more for companies as they increase their earnings. Those same $2.00 per share from Intel (and likely more) will garner a higher multiple, resulting in a higher stock price. So if the S&P 500 as a whole is going to earn $90 a share in say 2012, investors might be willing to pay 15x those earnings rather than the current 12x. That alone is a huge difference as the former results in a 1080 target and the latter a 1350 value.
This is exactly the reason the beginning of bull markets are so powerful. Investors work up the courage to bid up stocks before the economy fully turns in the anticipation that earnings growth will ramp up. Not only will earnings grow but the price that investors will pay for them will rise as well resulting in fat gains. We are not there yet, but history shows us that the time is coming.
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