The Market's Getting Cheaper
How can the market possibly be getting cheaper, when stocks have done this over the past year?
Well, there are two reasons a stock goes up or down in price:
1. The company makes more or less money (earnings rise or fall); and/or
2. Investors get more or less excited about a company’s future prospects, and accordingly ascribe a higher or lower multiple to those earnings at any given point in time.
Taking the first point first, as I feel we really must, company earnings have been on a one way march higher since 2022.
So the companies themselves have been making more money. But at the same time, the multiple that investors are prepared to ascribe to those earnings has actually been falling.
Because buyers are less excited about the prospects for future earnings growth, the market is actually cheaper today on a relative basis than it was a year ago.
So is this a good thing? Well on the face of it yes, it would indicate that investors aren’t yet too drunk on the AI Kool Aid, and there is some healthy scepticism that the explosive earnings growth we have seen in the early innings of the AI boom may not persist.
Previous stock market bubbles including, perhaps most relevantly given where we sit today, the Dot Com Crash have been foreshadowed by eye watering stock market valuations. And we just don’t have those right now.
Where we might run into a spot of bother however, is if the market is getting cheaper because the denominator (earnings themselves) turns out to be artificially inflated.
The bears would say that the circular financing that is fuelling the AI build out is unsustainable, and if one part cracks the whole thing will come apart at the seams.
Although the Information Technology sector represents 31% of the global stock market at the moment, it is projected to contribute 55% of total 2026 earnings growth. So this theme is absolutely foundational to the underpinning of the market as it stands.
The reasons that drawdowns for equity markets, typically during recessions, get so ugly is that the two reasons for stocks to go up can also move into reverse at the same time.
Earnings go down (because recession) and investors naturally feel more fear about the future, so they also ascribe a lower multiple to those depressed earnings. Just look at where the earnings multiple got to during the GFC in the last chart above for example.
So, what to do? Well, as you might expect me to say - I don’t think there is much you can or should be doing with this.
One of the difficult things about being someone who takes an interest in the markets is that we can never know in real time what is “priced in”.
Maybe valuations have been falling because investors, in aggregate, reckon that earnings (growth at least) is a bit inflated. Maybe it’s not priced in, and maybe the lower multiple is just a feature of the higher denominator.
History also tells us that valuation is a crappy predictor of short term returns, and therefore making a major change to asset allocation based on valuation is fraught with danger.
In this case specifically we could just be at the start of a technological revolution that will drive value wealth creation for those who own assets. Taking a massive chunk out of your equity allocation now would run the risk of missing out on one of those periods of intense growth that have historically driven long term returns for equity investors.
As ever, the best advice is to ensure you have an asset allocation that aligns with your personal time horizon (and stomach). And the good news is, if you want to add some bonds as some insurance within your portfolio - they are on sale at the moment.
Past performance is not indicative of future returns. None of the above should be regarded as investment advice to any individual, if you have any queries regarding your individual position please consult with a regulated financial adviser.
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