A buzzing about the “over-valued” market persists, reminding us that some people have been wringing their hands about the next crash ever since the last one. We understand the nervousness, but we also understand that it’s founded in misunderstandings of stock prices and corporate earnings.

The graph below shows three measures, on two scales. The far right scale shows actual and forecast operating earnings per share estimates for the S&P 500, and are represented by the orange and red lines, respectively. The left scale shows the operating P/E ratio, and corresponds with the blue line. The orange line stops in 2015 because it shows actual earnings, while the red line goes forward from 2015, showing the average estimate of analysts for future S&P 500 earnings. The graph goes back to the first quarter of 1988.


Notice first that the blue line – the P/E ratio – is significantly more volatile than operating earnings, the orange line. P/E ratios from 1990-94 were very volatile, despite only a slight decline in actual operating earnings due to the 1991 recession.

Lesson 1: P/E ratios, and therefore stock prices, are nearly always more erratic than the health of the underlying businesses themselves. 

In 1999, the tables turned, as tech stock fever swept through the market: actual operating earnings grew slightly, but not anywhere near the rate that stock prices appreciated. The 2000-03 bear market was related to an actual decline in earnings, and of course the 2008-09 recession and bear market were linked.

Look again at the orange line, after both the 2000-03 and 2008-09 recessions: with the exception of a few horrible quarters for operating earnings, the general trend of growth in operating earnings continued, with only slight changes in the slope of the line.

Lesson 2: Operating earnings, while far less fickle than P/E ratios, are more volatile than the underlying earning capacity of companies, as demonstrated by the longer term trend line in operating earnings. 

The current S&P 500 operating P/E is 18.55, which is roughly in the middle of the range over the last quarter century. Yet, because the market has appreciated for the last six calendar years, some investors and financial reporters express fear that we’re in for another drop. Forecast operating earnings (the red line) may be a little more optimistic than they should be, but everything analysts are measuring suggests to them that companies’ basic earning capacity will continue apace.

Lesson 3: Stock prices are volatile, but they’re not random – they’re tied to companies’ actual reported operating earnings and their underlying capacity to produce profits.

The bear markets shown in the graph above bring back some horrible memories for all of us. “Why didn’t I just pull my money out of the market when it got over-valued?” is a question that plagues the minds of many.  But while it would be nice to avoid bears and crashes, when we’re in the middle of a bad market, who among us can tell the difference between the 2011 Summer Swoon and the 2008 crash? And even if we could avoid the drop (human psychology being what it is), how could we be sure to get back in at the right time?

Lesson 4: Market timing is a unicorn. You can’t do it consistently, and neither can any professional. 

At Peloton, we look beyond the near term discomfort of volatile markets and anticipate the longer-term value of well-run, innovative companies. The U.S. is open for business: companies are operating efficiently, banks are well-capitalized, new products and services are springing up all around. At some point in the future, there will be another bear market. But while we, like you, won’t enjoy that climate, we also know that the underlying fundamentals will ultimately prevail. It’s in those underlying fundamentals that we spend our time.