Higher for longer rates may mean lower for longer stock multiples, and stock prices

As earnings season starts, the biggest concern is not necessarily that earnings will decline. The biggest concern is that investors may not be willing to pay the same amount of money for earnings, even if the actual profits don't change much. When interest rates began declining in November of last year, stocks immediately rallied. Stock prices are based on dividend yields plus an estimate of the rate of annual earnings growth. Earnings estimates did not suddenly rise dramatically. Earnings estimates for the S & P 500 this year is $243, according to LSEG. That is almost unchanged from the start of the year. Earnings estimates remain strong because of the underlying strength of the economy What did change was the multiple investors were willing to pay for a future stream of earnings (the price-to-earnings, or P/E, ratio). As rates have shot up quickly in the past few weeks, investors are willing to pay less for that future stream of earnings, even if the profit estimates are unchanged. The P/E ratio: the 'speculative' element Vanguard founder Jack Bogle, in his classic investment book Common Sense on Mutual Funds , called the P/E ratio (also known as the multiple) the “speculative return” of the S & P 500. The multiple is an expression of how much investors are willing to pay for, say, $1 of future earnings. “The difference between the fundamental and the actual return on stocks, then, is accounted for by the element of speculation — that changing valuation that investors place on common stocks, measured by the relationship between the stock prices and the corporate earnings per share,” Bogle wrote. Let's say a stock is trading at $10 and the future stream of earnings (for next four quarters) is $1. The P/E ratio (multiple) is 10. The market is saying it is willing to pay $10 for $1 in future earnings. That multiple could change for two reasons. One reason is that the market comes to believe that earnings estimate (that $1) is under threat. Let's say investors come to believe that the company will only make 50 cents in the coming year instead of $1. The P/E ratio would then go to 20: $10/0.50 = 20. The second reason the multiple could change is if investors decided that $10 was too much to pay for $1 in future earnings. Investors might only be willing to pay, say, $8 for that $1 in future earnings. What would cause that to happen? A rapid rise in interest rates. P/E ratios usually have an inverse relationship to interest rates: a rapid increase in rates will usually cause P/E ratios to drop, even if earnings estimates stay the same. That's because higher rates increase the cost of capital for companies. With a decline in multiples, investors are not necessarily betting on an imminent decline in earnings. They are instead betting that the future stream of earnings is less valuable due to higher interest rates, even if the earnings stay the same. Which brings us to the multiple. That multiple for the S & P 500 went from roughly 17 times earnings expectations for the next year back in November, to 21.5 times forward earnings at the start of April. It is now down to 19.8, and looks like it wants to drop more. If that prospect depresses you, cheer up. The multiple is declining modestly because rates are rising, but the economy is strong and earnings expectations remain high If that changes — if we get higher rates at the same time the economy declines noticeably — that's called stagflation , when stagnant growth is coupled with lingering inflation. And if that happens, earnings estimates will decline along with the multiple. That will make this current, modest 3.8% decline in the S & P 500 look like nothing. The S & P could drop more than 10% should those concerns ever become the consensus view on Wall Street.