P/E ratios are the primary concern, with the S&P 500’s decline in 2022 that has been greater than the S&P 500’s average return over the previous century, according to Ned Davis Research.
As a result of a reduction in P/E ratios, the US stock market has dropped from more than 30 to less than 20 during the last year. This is a significant decrease. For example, compared to a year earlier, the P/E multiple would have decreased by 28% due to the S&P 500’s 6-percent decline.
Among other things, inflation was a contributor. One of the most crucial variables is inflation. P/E multiples are directly related to this metric. When inflation is low, P/E multiples are lower, and when inflation is high, P/E multiples are greater. To a degree, this premise makes sense. A greater inflation rate indicates that future profits will be discounted at a higher rate, as many individuals have pointed out recently.
However, this is just a partial explanation. In a piece six months ago, I noted that nominal corporate profits per share expand quicker when inflation is strong. As inflation has risen over the last 150 years, the stock market has remained relatively undamaged.
“Inflation illusion” is a term used to describe this phenomenon, which helps explain the findings. Inflation illusion refers to the propensity of nominal incomes to increase faster under high inflation conditions. This is a problem for both investors and business leaders. According to FactSet, the percentage of S&P 500 businesses noting inflation as a factor in their first-quarter earnings calls has grown to 85%, the highest level since at least 2010.
Instead of lamenting the blunders of other investors, it would be more prudent to wager against their incorrect assumptions. One method would be to place purchase orders below the market price for companies with excellent profits. Then, you may be able to buy some of those companies’ shares at a bargain if investors are unjustly penalizing them. According to history, if this is the case, you should expect to make a sizable profit in the future.