On November 3, 2015, the S&P 500 Index (a better measure of the overall market than the Dow Jones Index) stood at 2,109.79. As I write (on January 14), the S&P 500 stands at about 1,880, a decline of almost 11%. What, if anything, does this mean for the valuation of privately held companies and the 2016 M&A environment? In order to attempt an answer to this question, we must understand certain basic principles of stock valuation.

Valuations of public and private companies depend on 2 factors—expected future earnings and the discount rate at which those future earnings are “discounted” to present value. Future earnings are, of course, speculative but there is typically a “consensus” future earnings expectation based on the work of analysts who cover particular public companies. The current price of the S&P 500 Index can be expressed as a Price/Earnings ratio where the “earnings” refers to the estimated future 12 months earnings. This “forward Price/Earnings ratio” currently stands at about 17, meaning that the 1,880 value of the S&P mentioned above reflects estimated 2016 earnings of about $111 (1,880 divided by 17). By contrast, in late 1999 at the height of the dot-com bubble the forward Price/Earnings ratio was about 24. In 2007–2008, just before the Great Recession, the forward P/E ratio hovered around 15.

Now these ratios are not the whole story because prices are not just dependent on the next 12 months earnings, but on the longer term prospects for the Company. Also, the rate at which future earnings are “discounted” varies. The current very low interest environment tends to depress stock market discount rates, which means that future earnings are more valuable today and will support higher stock valuations.

One might think that the recent increase of short-term interest rates by the Federal Reserve would increase the discount rate and thereby reduce the value of future earnings and stock prices. However, there is no evidence for this. The investment horizon for equity investors is more in the range of 5–20 years and interest rates for securities in that time frame have not increased. For example, the 10-year Treasury has fluctuated between 1.6%–2.5% over the last year and recently traded at 2.1%. This is a slight decline since the Fed announced its rate increase.

It might be the case that the recent stock market decline indicates that investors expect business earnings to be lower in the near to mid-term future. This might reflect recent turmoil in China and the continued decline in energy prices (although most analysts think cheap energy is a net plus for the economy). Lower future earnings would indicate a bearish view of the U.S. and world economy. A recession would certainly have a negative impact on M&A activity—investors are reluctant to make large commitments during uncertain economic times and deal activity always drops off during a recession. But does an 11% pull-back in the stock market mean a recession is looming? Since World War II, every recession has been preceded by a 10% or greater decline in the stock market, but there have been 3 times as many 10% market declines as there have been recessions—or as one wag put it, the stock market has predicted 30 of the last 10 recessions. The stock market is volatile and sometimes it is just blowing off steam.

2015 was one of the best years ever for M&A. Dealogic (an M&A research firm) expects deal volume both in the U.S. and abroad will set records when all of the numbers are finally tabulated. A fourth quarter 2015 survey of M&A professionals and CEOs by Dykema (a national law firm based in Chicago) suggests that M&A activity in 2016 will continue to be robust with professionals expecting an increase in deal volume over 2015.

Another indicator of future M&A activity is the tremendous amount of capital that has been raised by private equity firms to invest in acquisitions. This so-called “dry powder” or “capital overhang” was approaching $1.4 billion in the fourth quarter of 2015, an increase from the $1.2 billion level seen in December 2014 (source: Preqin Performance Analyst). These dollars typically come from pension funds, high net worth individuals, and family offices looking for higher returns than are available elsewhere. Also, U.S. corporations today sit with large amounts of cash on their balance sheets which is available to be invested in acquisitions. At the end of third quarter 2015, S&P 500 corporations had $1.45 trillion in cash on their balance sheets, an increase of 5.8% year over year. Goldman Sachs predicts that the amount of cash spent on investments by these companies will increase by about 3% in 2016.

The biggest factor governing M&A activity is the larger economy—during good times, M&A flourishes and during recessions it grinds to a halt. The consensus among professional economic forecasters is that a recession is possible but unlikely (a bold prediction!). The secondary indicators such as interest rates and the availability of capital all suggest that 2016 will be another good year for M&A. Not all tremors forewarn earthquakes.

Published in Business2Business magazine, February 2016