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Stock Market Tsunami Siren Sounds A False Alarm?

Wolf Richter sounds the alarm about the S&P 500's current price earnings ratio:

This chart shows those adjusted earnings per share for all S&P 500 companies (black line) and the S&P 500 index (blue line). I marked July 2012 and March 2014 (via FactSet, click to enlarge):

Given that there has been zero earnings growth over the past three years, even under the most optimistic "adjusted earnings" scenario, and only about 2% per year on average over the past five years, the S&P 500 companies are not high-growth companies. On average, they're stagnating companies with stagnating earnings. And the price-earnings ratio for stagnating companies should be low. In 2012 it was around 15.5. Now, as of July 7, it is nearly 26.

Wolf Richter: The Ballooning S&P 500 P/E Ratio, January 1 each year, plus July 7, 2017

In other words, earnings didn't expand. The only thing that expanded was the multiple of those earnings to the share prices - the P/E ratio. Such periods of multiple expansion are common. They're part of the stock market's boom and bust cycle. And they're invariably followed by periods of multiple contraction.

Before we go any further, let's acknowledge that Wolf would be absolutely right if earnings were the fundamental drivers of stock prices.

Unfortunately, they're not. Instead, dividends serve that function (here's the math and several years of forecasting results to back that claim up).

From that perspective, the seeming inexplicable levitation of stock prices is completely understandable during this period of time. When Wolf looks at stagnating companies in the years between 2012 and 2017, there is perhaps no better example of the kind of performance he describes than oil producers, where beginning in mid-2014, with the crash of global oil prices, their earnings crashed right along with their revenues.

By Wolf's reasoning, there would be no reason for the stock prices of these companies to continue to remain elevated

This article was written by

Ironman is the alias of the blogger at Political Calculations, a site that develops, applies and presents both established and cutting edge theory to the topics of investing, business and economics. We should acknowledge that Ironman is either formerly or currently, and quite possibly, simultaneously employed as some kind of engineer, researcher, analyst, rocket scientist, editor and perhaps as a teacher of some kind or another. The scary thing is that's not even close to being a full list of Ironman's professions and we should potentially acknowledge that Ironman may or may not be one person. We'll leave it to our readers to sort out which Ironman might behind any of the posts that do appear here or comments that appear elsewhere on the web!

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