So far, 2022 has seen some fairly significant stock market declines. The S&P 500 has fallen 19% and the Nasdaq 100 is down 28%. By comparison, the FTSE 100 hasn’t fared too badly, but even it is down 3.5%.
Investing
Investing is about paying out money today to get more money back in the future. In the stock market, the future money comes from the earnings that a company produces.
Let’s take Tesco (LSE:TSCO) as an example. The share price is down around 8% since the beginning of the year.
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Last year, the company produced 19.1p in earnings per share. If Tesco’s earnings increase at around 4% per year, the business is going to produce somewhere in the region of £3.82 in earnings per share over the next 15 years.
Tesco’s share price is determined by how much investors are willing to pay today for that £3.82 in future earnings. At the start of the year, investors were willing to pay around £2.93. Now, they’re only willing to pay £2.72.
It’s not just Tesco – this is largely true across the board. But why are investors willing to pay less and less for Tesco’s future earnings?
There are a lot of reasons share prices are falling. But I think there are three main causes of the stock market as a whole coming down.
Inflation
Inflation means that the value of cash today is higher than the value of cash in the future. In other words, given a choice between £100 today and £100 after 15 years, it makes sense to take the money now, since it will be worth less in the future.
Lately, inflation has been high and it seems to be persistent. So £3.82 in future earnings from Tesco is worth less than it would have been otherwise. Investors recognising this causes Tesco’s share price to fall.
Interest Rates
Higher interest rates mean that an investor can earn a better return on their cash without investing in a business. To achieve a return of £3.82 over 15 years with interest rates at 1%, an investor would need to pay out £3.39 today. With interest rates at 2%, the outlay today goes down to £3.01.
Recently, interest rate have been rising, increasing the amount that investors can make without buying shares. As a result, the amount that investors are willing to pay today for a £3.82 return from Tesco stock is decreasing.
Recession
Returns from stocks are uncertain and sometimes companies produce less than expected. While it’s sometimes possible to make an educated guess at what a business is going to earn over the next 15 years, returns can come in below expectations.
Talk of recession casts doubt over Tesco’s future earnings. If it looks likely that the company’s earnings will be £3.32, rather than £3.82, the amount investors are willing to pay today for a share of those returns is also going lower.
Conclusion
It’s hard to know when the current decline in share prices will turn around. High inflation, rising interest rates, and the threat of recession might be gone soon or they might be with us for a while. But at times like this, understanding why share prices are going down makes it that bit easier to wait for the storm to pass.
