2019: The Year of Massive Multiple Expansion!

February 03, 2020
By Patrick V. Masso, CFA

Large cap US equity markets posted a banner year in 2019. The S&P 500 Index generated a total return of 31%! However, corporate profits did not grow in 2019 – they flatlined!

The result was massive “multiple expansion”. Let me explain.

Comparing an asset’s price to the underlying earnings stream it generates is one way to gauge the degree to which an asset is cheap or expensive. This can be done at the stock index level. This results in a simple fraction, with price (“P”) as the numerator and earnings (“E”) as the denominator.

Coming into 2019, the P/E ratio of the S&P 500 Index was 16.36x. By the end of the year, the P/E ratio had ballooned to 21.17x. In other words, the S&P 500 Index became nearly 30% more expensive over the twelve-month period.

Another way to think about this subject is by decomposing the returns of an index into the two components of the fraction – “P” and “E”. In 2019, the 31% return for the S&P 500 Index was almost entirely the result of the price increasing. Earnings were flat for the year (see blue bars on the following chart).

Below you can see the P/E ratio increasing over the course of 2019, after plunging in late 2018.

Would you pay 30% more for an asset that generates the same amount of earnings it did a year prior? In 2019, the market voted a resounding “Yes!”


One reason the domestic stock market surged so much, despite languishing earnings, can be attributed to interest rates. The 10-Year US Treasury Yield declined from 2.74% to 1.87% in 2019. A decline in interest rates is typically supportive of equity prices.

The Federal Reserve clearly made a monetary policy error at the end of 2018 by raising interest rates. They created economic conditions that were too restrictive.

What a difference a year makes! The Federal Reserve, after equity markets declined 20% in late 2018, eventually realized they had made a mistake and spent 2019 atoning for their sins. They began by softening their language at the end of 2018 and eventually cut the Fed Funds rate three times.

As we entered the fourth quarter of 2019, liquidity problems began emerging in the repo market. The repo market is a short-term lending/borrowing market, but how it functions specifically is beyond the scope of this article. Suffice it to say, this was a meaningful problem in the “financial plumbing” that wasn’t going to resolve itself.

To combat the issue, the Federal Reserve ended up stepping into the repo market and flooding it with oodles of liquidity – nearly half a TRILLION dollars (and counting) – to ensure it continued to function as desired.

Over the last decade, one of the key lessons to be learned is that investors in risky assets, such as stocks, salivate at the thought of additional liquidity coming to market from central banks. In response to this liquidity injection by the Fed, buyers stepped up hand over fist in Q4 2019 to gobble up as many risk assets as they could. This pushed equity market prices through all-time highs in the case of the S&P 500.

That is one way to generate a 30% return, but is it sustainable?

The key takeaway from 2019 is that prices can make substantial movements higher despite the trajectory of earnings. Over the long haul, however, history suggests earnings do matter to the future path of stock prices.

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