Bouncing Ball & Multiple Expansion?

I’ve said it here multiple times that when markets move in one direction too long, they often have a countertrend move that is half of the previous move.  The Dow Jones was at 9653 on election day (November 4th) and fell to an intraday low of 7449 over the next several trading days.  That was a 23% drop pretty much straight down.  In two days, it bounced half way back up.  In other words, we dropped 2204 Dow points from November 4th until November 21st (intraday).  Now, we have jumped half of that drop, or 1158 points to the intraday high yesterday.  That’s perfectly normal.  Picture dropping a ball off of a building.  It wouldn’t bounce back to the roof where you dropped it from.  It would bounce back maybe 1/3 or 1/2 way back up.  That’s exactly what the market has done in the last few days.  What’s interesting is that when it’s hit that level of around 8600 on the Dow, it has failed 2 days in a row.  In addition, we’re also right below the 21-day moving average, a place rallies have failed in the past.  So, one test to see the longevity of this rally will be if we can move up from here and break through some of these technical levels.

Multiple Expansion? 

In good markets, we always hear about multiple expansion.  The means P/E ratios getting larger.  In other words, if a stock earns $1 per share and the stock is at $10 per share, then it’s P/E ratio is 10.  So people are willing to pay for 10 years worth of earnings today.  When investors are really happy and bullish, they may pay for 20 years worth of earnings, or a P/E of 20.  That would mean the company is still earning $1 per share, but the stock is now $20 per share. 

There’s one other way we can get multiple expansion.  We can have the “E” in the P/E fall.  So, what if the stock is $10 per share but the company now earns $.50 per share?  That’s a P/E of 20.  So, be careful.  I hear everyone on television saying stocks are cheap.  Some are and some aren’t.  But, if you’re not confident in the “E” part of the equation, then you can’t trust the “P” part either.  I think overall, earnings for a lot of companies are still too high based on the estimates by analysts. 

Therefore, we may get multiple expansion, but it’s not the kind you or I want.  We want it because people are more excited about buying stocks and are more willing to pay even more for a years worth of earnings.  I think the multiple expansion (if it comes) will come from the earnings going down faster than the stock prices.  A more realistic scenario is that stock prices will come down just as fast as the earnings.  So, if earnings fall 20%, then prices will have to fall 20% to have the same P/E as we do now. 

The P/E may be fine at 10, but that doesn’t mean the stock can’t go down much further and still have a P/E of 10.  As always, make sure you’re doing your homework not just on past information but current information and (realistic) projections.

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