Elnora H. and William B. Quarton Professor of Business Administration and Economics, Coe College, Iowa
Check-in for Q4 2023, 11/2/2023
The trajectory of the stock market for the near future has become much clearer. 2022 was a year of adjustment to the new reality of a higher interest rate environment. All investment yields are anchored to the Fed’s Federal funds rate. When the rate rises, all yields must also increase to maintain a healthy risk premium. The P/E ratio is the inverse of the earnings yield. It must decrease when the interest rate rises. However, earnings don't fluctuate significantly in the short term. As a result, stock prices must fall rapidly to account for a higher earnings yield. This is what transpired in 2022.
2023 seems to be a year of lateral movement in trading. This is understandable since the market is still trying to figure out the Fed's intentions (it's possible the Fed is uncertain as well). Now that inflation has been tamed, it's evident that the Fed has stopped raising the rate. The interest rate will either remain at its current level or begin to decline. Consequently, the P/E ratio will either remain stable or start to rise.
If the P/E ratio remains constant, then earnings will dictate stock prices. This correlation is evident in the current earnings season. Tesla failed expectations, while Amazon exceeded them. Tesla's stock plunged, whereas Amazon's soared.
The prevailing sentiment is optimistic. Investors are beginning to consider riskier investments. This shift is evident in Bitcoin's recent price surge. My new favorite, LLY, announced lukewarm earnings today, yet the market's response was overwhelmingly positive. This is another indicator of a bullish momentum.
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