Nov 25, 2018 - Economy & Business

The good news in the stock market decline

Data: Factset; Chart: Lazaro Gamio/Axios
Data: Factset; Chart: Lazaro Gamio/Axios

Axios told you on Tuesday that 2018 has been "brutal" for the stock market, and Bloomberg's Stephen Gandel followed up on Wednesday by saying that it's even worse than that. Above is a chart of one key valuation metric: the stock market's price-to-earnings ratio.

For the first year of the Trump presidency, valuations rose steadily. But in his second year, they've imploded and are now well below their level when he took office. The S&P 500 now trades at 17.5 times its earnings over the past 12 months. That's down 25% from the peak of 23.4 in January.

The big picture: This is not bad news. In many ways, it's exactly what you'd expect from a president who came in to office promising a large corporate tax cut.

  • Lower corporate taxes mean higher corporate earnings. Therefore, as the tax cut becomes increasingly likely, stock prices rise in anticipation of those higher earnings. That drives p/e ratios higher.
  • Once the tax cut arrives, earnings go up, in line with expectations. But the higher earnings mean a higher denominator for p/e ratios and therefore lower multiples.

The bottom line: When the market trades on a trailing p/e of 17.5, it no longer looks particularly frothy. Stock prices can certainly fall from these levels, especially if a tight labor market forces companies to pay their workers more and eats into profit margins. But most Americans would prefer higher wages to higher stock prices.

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