Hello! Welcome back to Reflections on Investing with the Cornell Capital Group. This week, we're going to follow up on what we started last week. Recall that last week we talked about how much the S&P 500 had risen since January of 2019, and we focused on earnings. We said that earnings had risen sharply, but that increase was in large part due to low interest rates and low taxes. Both of those engines had run their course, and in fact, some of them, like taxes, and for that matter, interest rates, may even reverse direction. However, we didn't tie it all together—we just looked at earnings.
So, let's go back to the index and tie it all together by bringing in the multiple.
If we go over to the computer here, we have the S&P 500 Index, showing what happened from January of 2019 to the present—the present being September 18th, 2024. It started at 2,506 and ended at 5,713, an increase of 128%. That increase has to be due to a combination of two things: a rise in earnings and an increase in the number of dollars that investors would pay for each dollar of earnings, which is the P/E multiple.
Let's look at the pieces.
First, earnings. The earnings on the S&P 500 started at about 137 and rose to 206, an increase of 54%. So, the earnings that we were talking about last week accounted for a rise in the index of 54%, but the index rose 128%. Therefore, during this period, investors must have been willing to pay more and more for each dollar of earnings, and that's the P/E ratio.
Here's the P/E: it started at about 18.5 and over the period rose to 27.7—an increase of 48%. If you take that 48% and compound it with the 54% earnings increase, you get the 128% increase in the S&P 500.
Now, if we're going to continue to have outsized increases in the index, it has to come either from earnings or from the multiple. Last time, we said we felt the dramatic increase in earnings based on interest and taxes had largely run its course.
What about the P/E ratio? Can that continue to expand and thereby increase the index?
The P/E ratio depends primarily on two key things: expected future growth in earnings (which we've already said we believe is plateaued) and the so-called equity risk premium. On that basis, the P/E ratio might even decline, as earnings growth expectations could fall slightly.
The equity risk premium refers to how much investors require over the yield on Treasury bonds to hold stocks. The more investors are willing to hold stocks for a low equity risk premium, the larger the P/E ratio.
What's happened to this equity risk premium? Well, it's a little bit hard to measure, so I'll give you the estimate provided by StarMine, which is a subsidiary of Refinitiv, a database owned by the London Stock Exchange. If I used a different measure of the equity risk premium, such as that calculated by my colleague, Professor Aswath Damodaran, it would look about the same.
Here's the equity risk premium estimated by StarMine over the period: it starts at about 6.4%, stays there for a while, but ends at 3.76%—not much of a premium over bonds, down 40% during the period.
Now that you know all the pieces, you can ask yourself: if I think that stocks are going to continue to offer superior future returns, what's the driving force going to be? Is it going to be earnings, or is it going to be the multiple?
In our analysis here at the Cornell Capital Group, we don't see it being much of either. In other words, we feel that going forward, earnings growth will be slower, and the P/E multiple will remain constant or even decline.
That's why, at this point in time, we're taking a very conservative stance. You may disagree, but if you do, you should go back to the underpinnings—earnings and multiples—and decide which one you think is going to drive the market higher in the future.
This has been Reflections on Investing with the Cornell Capital Group. Thanks for listening!