Falling valuations ≠ falling stock prices 🤔
The most important thing to remember about shrinking valuations 📉
Stock prices have been falling since the beginning of the year. The S&P 500 is down 18% from its January 3, 2022, closing high of 4,796.
However, stock valuations — as measured by the forward price-to-earnings (P/E) ratio — have been falling since August 28, 2020. The S&P closed at 3,508 when forward P/Es peaked, meaning stocks actually generated a 12% return as valuations have been falling.
For investors thinking about trading based on value, it’s incredibly important to remember stock prices don’t have to fall for valuations to fall. This is especially the case when earnings are growing, and earnings have been trending higher for decades.
The mathematical nuance behind this is pretty basic and straightforward, but for some it may not be immediately intuitive. The idea of falling valuations tends to have a negative connotation, so it’s understandable that you might default to thinking that prices should fall.
All of this is very relevant right now, especially with many experts arguing that stock market valuations should come down.
If you’re comfortable with all of this, then you can probably stop reading. If you’re looking for a little more color, then please read on…