Financial Briefs


Market Melt-Up Risk Grows

This is not a prediction but, if you do the math, earnings could drive the stock market higher in the months ahead. Predicting the market is risky business but professional prudence requires a realistic set of expectations about the future supported by math. Professional prudence requires realistic expectations supported by math. The current math indicates the market is at risk of melting up.

To be clear, a lot of people think the stock market is not connected to any reality, irrational, whimsical, or like going to a casino. But that’s not how financial economics works. While earnestly attempting to avoid hyperbole or sensationalism, here’s the math explaining why the stock market could rise sharply in 2022, why a virtuous cycle is being triggered in which economic growth causes earnings growth at America’s largest public companies, driving stock prices higher.

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Although markets may form bubbles, bubble barometers are currently nowhere near the red zones reached during the last stock market bubble, which ended with the tech stock bust of 2000. For instance, the consumer sentiment indicator, which grew irrationally exuberant in the last bubble in stocks in the late 1990s, is currently depressed compared to its long-term trend in the gray line.

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Meanwhile, household net worth, a quarterly figure from the Federal Reserve, released December 9, for the period through September 2021, has surged during the pandemic on stock market and real estate gains. The “wealth effect” historically kicks in and ebullient investors reinvest their gains, and it creates a circular dynamic. When household net worth goes higher, it stimulates spending, which stimulates higher stock prices. And you can have a virtuous circle. So, household net worth can be a significant measure, and the wealth effect is something real, and it is doing something that hasn’t happened since the last bubbles in both the stock market and real estate.

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Ultimately, however, earnings drive stock prices and doing the math indicates a surge in stock prices could occur. Fritz Meyer, an independent economist, says the S&P 500 stock index is currently trading at a multiple of 21 times their expected earnings for the 12 months through the end of 2022. If you apply that same forward earnings multiple of 21 to the earnings expected in 2023, where would that put the Standard & Poor’s 500 stock index at the end of 2022? The answer: the S&P 500 would be priced at 5122 versus its closing value midday price of 4626. That would be about a 10% gain, and it would follow on a gain, so far in 2021, with only two weeks let in the year, of 25%.

Let's just do the arithmetic. Twenty times forward earnings at the end of 2022 would put the market at 4878, and today we're at 4625 today. If you apply a forward earnings multiple of 21 times that 2023 estimate, we would be at 5100 at the end of next year. And if 22 times, we'd be at 5300. Simply doing the arithmetic, applying a forward P/E multiple to earnings estimates a year from now, trying to figure out where we could possibly be on the S&P 500 a year from now.

In the stock market bubble of 2000, the S&P 500 traded at more than 24 times expected 12-month earnings throughout 1999 and into early 2000, according to data from Yardeni Research. A 24 multiple would take stock prices higher by about 20%. Heightening the risk of a melt-up in stock prices, yields on bonds have never been as low in U.S. history. With bonds so low, stock valuations could head higher because bonds – the usual alternative to stocks -- are less attractive relative to stocks.

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This article was written by a professional financial journalist for Pacific Crest Financial Advisors, LLC and is not intended as legal or investment advice.

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