Can Investors Trust the Stock Market Rally?

“You could almost argue that we’re in a bull market and a bear market at the same time,” said Eddie Perkin, the chief equity investment officer at Eaton Vance, a Boston-based money manager.

On Monday, the SP 500 fell 1.8 percent, as investors dumped retail, hospitality and energy shares amid the darkening outlook for economic growth.

While investors might be tempted to buy stocks now, before the market starts surging higher, many of them are torn. That’s because the recent stock market rally combined with the pandemic has pushed price-to-earnings ratios incredibly high. It’s no overstatement to say the market is the most highly valued it has been in almost two decades, just as the country plummets into what’s expected to be the deepest recession since the Great Depression.

Typically, investors calculate a stock’s value by comparing the price of a share with its earnings. The higher the ratio, the more expensive the stock is considered. The calculation can be applied to all 500 companies in the index to assess whether the market as a whole is overvalued or undervalued.

When investors are optimistic about future earnings, they’re more willing to pay higher prices for expected earnings, generating a higher price-to-earnings ratio — sometimes just called the P/E ratio. When they’re pessimistic, they’re less likely to pay a lot for the earnings that have been forecast, in part because they’re skeptical those earnings will be produced. That typically results in a low P/E ratio.

When the market collapsed last month, the P/E ratio plummeted. But it began rising in recent weeks, and could climb further if the market merely remains steady.

The reason: Public companies are beginning to report their first-quarter results. Many will report drastically reduced earnings, with profit expectations for the rest of the year looking grim.

Article source: https://www.nytimes.com/2020/04/20/business/stock-market-rally-coronavirus.html