The S&P 500 is Increasing by 25% Because Investors Don't Focus on Fundamentals

Recent intraday market fluctuations underscore how susceptible stocks are to shifts in investor sentiment. For instance, on November 19, the Dow Jones Industrial Average (DJIA) experienced a sharp drop of over 400 points shortly after the opening bell, only to recover and end the afternoon relatively unchanged. Such dramatic reversals cannot be fully attributed to market fundamentals; instead, they reflect the volatile nature of investor emotions.

‍

Earnings-Driven vs. Sentiment-Driven Markets

A bull market rooted in strong corporate earnings offers a much sturdier foundation than one driven by investor sentiment. The current market, however, appears to rely heavily on mood swings, leaving the bulls on shaky ground.

‍

Over the past five years, if the S&P 500 had risen at the same pace as earnings per share, the index would be trading below 4,500, representing a roughly 25% decline from its current level. Instead, the S&P 500 sits above 5,900 due to a significant expansion in its price-to-earnings (P/E) ratio during this period.

‍

The Role of Earnings and Sentiment

The extent to which earnings or sentiment influences the market varies depending on the time frame of analysis. David Rosenberg, founder and president of Rosenberg Research, analyzed their respective roles over a one-year horizon. He observed that while the U.S. stock market has risen 41% over the past year, corporate earnings have only grown 4%. Without the notable expansion of P/E ratios, Rosenberg estimates the S&P 500 would be closer to 4,600.

‍

Ambiguity arises when defining earnings, as different approaches yield varying perspectives. Analysts may consider trailing 12-month earnings, forward 12-month earnings, or even the trailing 10 years’ inflation-adjusted earnings as used in Yale professor Robert Shiller’s Cyclically Adjusted Price-to-Earnings (CAPE) ratio.

‍

Despite these varying methodologies, the conclusion remains consistent: the recent bull market owes much of its growth to expanding P/E multiples rather than robust earnings increases.

‍

The Interest Rate Factor

The market’s vulnerability is further amplified by its divergence from a typical pattern: historically, P/E ratios tend to decline when interest rates rise, and vice versa. However, despite the yield on the 10-year U.S. Treasury bond more than doubling over the past five years, the stock market has seen P/E ratios expand rather than contract.

‍

This anomaly can be explained through the lens of discounted cash flow analysis. Lower interest rates increase the present value of a company’s future earnings, justifying higher P/E multiples. Conversely, higher interest rates reduce this discounted value. Based on this principle, today’s elevated interest rates should theoretically result in lower P/E ratios than those seen five years ago — yet the opposite has occurred.

‍

The current bull market would appear far more stable if its expanding P/E multiples had been accompanied by a steady decline in interest rates. Instead, the coexistence of rising rates and inflated P/E ratios has created a precarious situation, heightening the market’s susceptibility to corrections.

‍

Investor sentiment, by nature, is unpredictable and prone to rapid shifts. As a result, markets are likely to see more significant swings akin to the dramatic moves on November 19. These could manifest as sharp intraday drops, unexpected recoveries, or even more severe downturns.

‍

The bottom line is that the market’s current reliance on sentiment-driven momentum and inflated P/E multiples, coupled with elevated interest rates, underscores its fragility. Investors should brace for ongoing volatility and remain cautious as these dynamics continue to unfold.

‍