The most basic measure of stock market value is the price-earnings multiple.
To calculate it, you take the price and then divide it by the earnings, which is arguably the most important driver of stock prices.
Over long-run, this market multiple has a tendency to revert to its mean.
But in the short-run, it’ll trend above and below the mean for long periods of time.
“Market multiples rarely trade at average levels,” said Morgan Stanley’s Adam Parker. It’s an obvious observation, but it may be the most important observation for anyone who considers valuation before making investment decisions.
Just because the multiple is above its mean doesn’t mean you should start shorting the market like crazy. Similarly, just because the multiple is below its mean doesn’t mean you should expect instant profits by buying stocks.
In 2013, nearly 75% of the stock market rally was driven by the expansion of this multiple, not earnings growth. This is what almost every strategist on Wall Street got wrong in their initial forecasts.
Investing based on value is a game of patience.
“The market can remain irrational longer than you can remain solvent,” said John Maynard Keynes.
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