On Normalized Earnings Stocks are Not Overvalued – YouTube Video & Transcript

In this video, C.J. Lawrence Portfolio Strategist and Client Advisor, Terry Gardner, introduces the concept of “normalized earnings” and makes the case that, on that basis, the stock market is not over-valued. Gardner incorporates the CJL Rule of 20, which was developed by C.J. Lawrence Chairman, Jim Moltz, in the early 1980s to corroborate that view. In addition, he reflects on recent video topics including “Looking Around Corners”, “Leadership From Financials is Essential”, and “The Tilted V Recovery”, all which can be viewed and reviewed on the C.J. Lawrence YouTube channel.

https://youtu.be/o7p_BRKwZRA

Video Transcript

Terry Gardner, Jr.:

Hi, good afternoon, everyone. It’s Terry Gardner from C.J. Lawrence on Monday, July 6th. Hope everyone had an enjoyable Independence Day weekend. I want to touch today on valuation on the market’s valuation. Before delving into that, I thought it’d be useful just to highlight a couple of recent videos that we’ve produced just to track on how those topics and issues are evolving. So if you remember a couple of weeks back, we talked about how the market continues to look around corners, grabbing new data, digesting it, moving, and then settling in before looking and digesting its next set of data. That pattern continues.

Terry Gardner, Jr.:

Secondly, we’ve been looking for the financials to see if they’ve outperformed the market. And at times they have, and at times they’ve not. So leadership from the financials looks to be something that is still absent from this market recovery and that probably bears watching. Confirming that is the performance of the 10 year US Treasury Bond yields, which is about 69 basis points today. It’s fluctuated between 65 basis points and 75 basis points. So we’d look for some confirmation there as well. So far, I would suggest that we haven’t seen that confirmation.

Terry Gardner, Jr.:

And then thirdly, we talked a couple of weeks about the tilted V recovery, which is still in our view very much intact. And the tilted V referring to both the economic recovery and the stock market recovery might be a little bit steeper in the stock market recovery, but tilted, we still think it is.

Terry Gardner, Jr.:

So I wanted to talk today a little bit about normalized earnings. As a former securities analyst, it’s something that we used to focus on when we saw dips in corporate earnings for non-recurring matters, a hurricane or an exogenous event. And we would suggest that the market is looking at the Coronavirus pandemic and associated shutdown as somewhat as a non-recurring event.

Terry Gardner, Jr.:

And so it’s looking out towards more normalized earnings for the S&P 500 to try to derive a valuation and a clearing price. And when you look at normalized earnings, you can see that the market may not be as expensive as some are suggesting it is. So just in simple terms and using our visual here, the S&P 500 earnings have grown at about a compounded rate of 11% for the last 20 years. So all I’ve done in this very simple drawing is to show if you extrapolate that 11% out, you have the two solid bars in terms of earnings. The dotted bars are where we actually are as a result of the Coronavirus related economic shutdowns. Okay.

Terry Gardner, Jr.:

So the market is actually looking at more normalized earnings than these depressed earnings. And on that basis, the market’s trading at about 18 times 2020 normalized earnings and that’s the earnings power of the underlying economy, if everything was working properly. At about 16 times 2021. So it’s really not too far out of whack with historical valuation measures. I’m just looking at my chart here too. Even if you took expected 2021 estimates as they exist today. And I would suggest those are somewhat depressed, earnings could come in, in 2021 higher than what the current Factset forecast, consensus forecast are suggesting. On 2021 numbers we’re looking at about a 19 times multiple. So you say, okay, well, that sounds high, but when you put everything in the context of inflation and interest rates, which are remarkably low, historically low, during periods, historically, when we’ve had low interest rates, we’ve had high valuations.

Terry Gardner, Jr.:

And that’s simply because there’s more of a demand for stocks. There’s no yield to be found in the bond market. And markets gravitate towards stocks and are willing to pay, or investors are willing to pay a higher price for stock earnings and dividends because there’s not much yield to be found in the bond market. And that’s the simple comparison. We’ve run a historic measuring stick, if you will to look at inflation versus market PEs. It’s a tool that our chairman Jim Moltz developed back in the early eighties called the rule of 20. And the rule suggests that if you take the market multiple and add the rate of inflation, historically over the last 40 plus years, the sum is equal to about 20. Well, so sure enough on a normalized 2020 estimates, that calculation would get you to 19.3. So below the rule of 20 threshold, and on 2021 would get you to 17.5. well below, again, using what we believe would be normalized earnings.

Terry Gardner, Jr.:

And 1.3% expected inflation, which according to Factset is the consensus forecast for core inflation, core CPI for 2020 and for 2021, amongst the economists that they survey. Using actual learnings, these are forecast earnings for 2021, the rule calculation would get to about 20.3. So still very much in line with historic averages.

Terry Gardner, Jr.:

So that’s the point we want to make today is that the market on unexpected earnings does not look particularly expensive to us. It’s difficult to make the case that the market looks cheap. For sure it doesn’t, but at the same time, bargains can be found, reasonable prices can be paid for companies for their stocks that are growing at good rates. So that’s our message for today.

Terry Gardner, Jr.:

If you’ve got any questions, feel free to give us a ring. And by the way, all of our historic videos are archived on our YouTube channel and texts of them with charts are on our website at cjlawrence.com. Please feel free to check those out and follow them along. If you’ve got any questions give me a ring (212) 888-6403. Or shoot me an email at tgardner@cjlawrence.com. Have a great week.