Momentum trading had surely pushed some high fliers into frothy territory, so a correction is correct. But skeptics and short traders claim the market as a whole still remains totally disconnected from “fundamentals.”
Other commentators suggested investors were suddenly terrified that Congress had not yet agreed to borrow and give away trillions more to “stimulate” something or other. “If we do not get another stimulus aid package in time,” warns Forbes columnist Naeem Aslam, “the economic recovery will remain fragile”(though it’s growing at a 26.2% to 29.6% rate). A recent Wall Street Journal story likewise warned that “failure by Congress to deliver additional relief measures for American consumers and businesses could weigh on market sentiment.”
Yet the disappearance of the “stimulus package” is old news. Most of it began and ended in April when nearly everyone received a $1,200 check, and PPP loans soon dried up. The extra $600 of weekly unemployment benefits ended July 31. Yet stocks were particularly strong in August. The rapid winding down of stimulus schemes from May to July was essentially irrelevant compared to April’s all‐important news that 28 states announced that they would be reopening from April 20 to May 4, soon followed by most others.
This brings us back to the more serious question – namely, the alleged disconnect between S&P 500 stock prices and “fundamentals.” This often boils down to the fact that stock prices seem high relative to past earnings. But the price/earnings (P/E) ratio can’t be understood without looking at bond yields. That is because a lower interest rate increases the discounted present value of future earnings.
The argument for stocks being greatly “overvalued” rests on the fact that the trailing P/E ratio rose significantly from May 1 to September 1. On January 1, the P/E ratio was 24.21 –about the same as two years before (24.87). Even after Covid‐19 and lockdowns crushed the economy, the P/E ratio was still 23.74 on April 1. Stock prices and earnings had both collapsed in sync. The P/E ratio was 25.10 on May 1 after the Fed funds rate fell to nil and the $1,200 checks and PPP loans peaked. It then rose to 26.69 on June 1, 27.57 on July 1, 28.31 on August 1 and 30.32 on September 1.