C.J. Lawrence Weekly – Stock Valuations and Earnings Growth Play Tug-of-War in Earnings-Driven Markets
Better-than-expected economic data released last week did little to buoy stock prices. The 49-year low in unemployment claims, impressive increase in the ISM non-manufacturing Index, jump in non-defense capital goods orders, and 2.9% year/year growth in wages all failed to propel the market higher. Instead, fears of escalating tariff wars and the potential for a corresponding deceleration in global economic growth dominated the financial news headlines and investors’ psyche. The S&P 500 Index was down 1% last week and is down 1.5% from the new high set on August 29. The stall, in the face of robust domestic economic data, has some market watchers asking if the stock market has lost a gear, or if it might be stuck in neutral. But it is not unusual for stocks to experience pauses, or even corrections, during transitions from price-driven to earnings-driven markets. Like the barking dog that finally catches up to the car, investors find themselves in the midst of the current earnings recovery asking the question, “what now?”
From the beginning of 2013 to the end of 2017 the S&P 500 Index price rose 87%. During that period S&P 500 earnings per share rose 25% while the Index’s price-to-earnings (P/E) multiple expanded by 62%. That mix is now reversing. The P/E multiple on the S&P 500, using next-twelve-months earnings, looks to have peaked around 18x in late 2017. The P/E now stands at 16.5x next-twelve-months earnings forecasts and at 16.2x 2019 calendar EPS estimates. Meanwhile, since December 2017, 2018 earnings per share forecasts for the index have increased 10.2%, and 2019 forecasts have climbed 10.0%. The P/E multiple on the S&P 500 has declined 9.4% during the same period. The tug-of-war between the market P/E multiple and the pace of earnings growth is pitched.
Earnings driven markets are characterized by compressing multiples and declining market breadth. The narrowing leadership makes outperformance increasingly challenging. In previous earnings-driven markets, premium valuations were often awarded to companies with consistent and visible streams of sales and earnings, and to companies that possessed the ability to grow sales and earnings faster than the rest of the market. Today, stocks with those characteristics are increasing found in growth sectors like Technology and Consumer Discretionary, and currently in select Industrials groups. Earnings-driven markets can move to new highs, but it is typically a small group of leaders that act as the propellant. To outperform, investors and managers need to be increasingly selective, identify new leadership early, and avoid the rest of the pack.