Although stocks do, over the long run, tend to reflect underlying profitability and growth, in the short term stock prices and reality are not even necessarily related.
In the short term, stock prices are largely dependent upon the mood of investors. During times of pessimism, a company's earnings of $1.00 per share may give the stock a value of approx $10-14, or a P/E of 10-14. During times of optimism, the exact same stock with the exact same earnings may be valued at between $17-20, with a P/E of 17-20 or higher.
At present, the DOW 30 Index (thirty of the largest corporations in the US) has a collective P/E ratio of approx 18. Is this cheap? No. Is this expensive? It depends on your expectations.
A P/E ratio of 18 indicates that investors expect the profitability of the companies in the DOW to improve. That is, investors are willing to pay a slight premium over current earnings, with the understanding that earnings in in the near future will be greater.
Yesterday’s selloff was thousands of investors second-guessing their expectation that the US and world economies will improve. If the US economy declines, today’s stock prices are indeed slightly overpriced. If the US economy improves – even modestly – today’s stock prices are perfectly in line: neither overpriced nor underpriced.
Many world markets are set to slow down or even decline, including mainland China, Hong Kong, Taiwan, Canada, Australia, Israel and others – all of which has been well-documented in this blog. Yet, the US market will continue to improve, albeit slowly, because of various factors that I will be covering in detail in the days and weeks to come. The US economy was hit by the crisis first, and it will also be the first to emerge from the crisis, potentially stronger and more competitive that it has been in decades.
The US recovery may stall temporarily, but it is not in jeopardy. But of course I must add this caveat – in the short term, psychology trumps intrinsic value every time. That is, being fairly valued does not mean that prices cannot fall. Since I have no crystal ball, I unfortunately cannot tell you what stocks will do tomorrow.
My advice, as usual, is to buy the stocks of solid companies that are valued as if the present gloom will last forever.
PS – Don’t go looking for bargains in the Nasdaq. Thank you.
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"Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions..."
Benjamin Graham
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