April was an extremely volatile month for stock investors. Even that might be an understatement.
In about four trading days, the S&P 500(SNPINDEX: ^GSPC) fell 15% from its intraday high to its intraday low for the month. Two days later, the Nasdaq Composite(NASDAQINDEX: ^IXIC) posted its second-biggest percentage-point increase in history, rising more than 12%. The S&P 500's increase of 9.5% was good enough for the third-highest since 1939. Stocks continued to trade up and down from there but rallied heavily to close out the month of April. Still, the benchmark index, the S&P 500, ended the wild month down 0.76%.
That might sound like stocks got a little cheaper last month, but the truth is they're actually more expensive today. Here's what happened.
Image source: Getty Images.
The stock market is facing a big challenge
The huge fluctuations in the stock market last month can be traced to a single entity. The Trump administration enacted heavy reciprocal tariffs on imports on April 2, sending the markets tanking on fears of how the policies will impact businesses, jobs, and consumers. When Trump paused most of the tariffs on April 9, the markets breathed a sigh of relief. However, the White House has continued to come out with rapid changes to its trade policy stances, giving the markets a lot of uncertainty.
As things stand today, most imports carry a 10% tariff, while Chinese imports require a 145% tariff. That alone is enough to weigh on some companies' earnings expectations. But the challenge is even greater for those trying to forecast more than a few weeks ahead because trade policies could seemingly change at any moment. Many companies withdrew their revenue and earnings forecasts during their first-quarter earnings calls over the last few weeks.
With the tariffs weighing on earnings and creating more uncertainty as to the long-run impact on the economy, analysts have been updating their earnings expectations for the companies they follow. Last month, they lowered their earnings expectations for Q2 by an aggregated total of 2.4% for the S&P 500 components. For the full year, analysts' earnings estimates have dropped 3.1% since January.
So, while the S&P 500 saw a 0.76% drop, earnings expectations dropped much more. As a result, the index's forward price-to-earnings (PE) ratio actually increased. In other words, stocks got more expensive.
The S&P 500 forward PE ratio now sits at 20.5 as of this writing. Near the market bottom of April, the forward PE looked like it was just 18.2, but many analysts had yet to update their forecasts for the impact of Trump's policies and earnings results from the companies they follow. As a result, stocks were more expensive than they looked.
There's a lot of uncertainty in the market. As previously mentioned, many companies have withdrawn their financial forecasts for the year as they try to get more data on how the President's trade policies will play out.
Tariffs could impact pricing, supply chains, and consumer behavior. On top of that, we recently saw Q1 GDP numbers come in well below expectations with minimal impact from tariffs. That indicates the economy is already faltering, and tariffs could create an even tougher environment for growth. That puts the Federal Reserve in a position where it would normally lower interest rates to help boost the economy, but tariffs could increase prices and push inflation higher, which would require higher interest rates to combat.
Warren Buffett offers some great advice for investors struggling with short-term uncertainty about the economy. In his 1994 letter to shareholders he wrote, "It is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable."
If you can find a solid company with a stock trading at good value in today's market, you shouldn't wait for prices to come down before purchasing it. That said, determining its fair value still requires you to make predictions about its future. You should still do that, but you need to determine how confident you are in those predictions.
The long-term trends in a business might not be heavily impacted by the current turmoil in the economy. On the other hand, an extended period of high tariffs could completely disrupt the progress of some businesses.
If your confidence about the future of a company falls, you should demand a higher margin of safety before you invest. A margin of safety protects you against being incorrect in your predictions. If you're wrong, you can still earn a reasonable return. If your predictions turn out to be accurate, your returns will be even better.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
