Anyone that studies the markets knows that for equities and certain classes of fixed income securities, it is earnings (or profits) that propel and support valuations. In the absence of growth in earnings, it’s hard to develop a scenario whereby stock prices would move higher. Likewise, when we expect a period of strong profit growth, we could expect prices to move higher.
The other important factor in stock valuation is the earnings multiple, or price to earnings (p/e) ratio. Investors typically expect to pay a multiple of current and/or expected earnings to acquire shares of a company. The magnitude of this earnings multiple fluctuates based on expectations for future profits, the economy, and other factors such as governmental policies. So, when evaluating whether or not a stock or group of stocks is appropriately valued, we must understand these factors.
To get a good handle on what a suitable valuation for the equity markets is, we first look to historical averages of the p/e ratio. As of June 15, 2018, the five-year average p/e for the S&P 500 Index has been 16.2X1, and the 10-year average has been 14.4X1 (we must bear in mind that the 10-year period includes the latter part of the financial crisis when the S&P 500 average fell precipitously, creating an anomaly). With this information, we are in a position to look at today’s market valuation with a reasonable frame of reference.
As of the beginning of June, the period that most S&P 500 companies report their profit results from the first quarter of the year concluded. This information is important because not only do companies report their results from the last quarter, but they also provide guidance on what they expect to see occurring with their businesses in the future.
On average, S&P companies have increased earnings by 26.6% over the same quarter a year ago2. This is the highest quarterly growth rate reported since late 2010. With that result, we have an S&P 500 Index that holds a current p/e ratio of 16.2X, exactly on its 5-year average.
To be sure, the passage of the tax plan has provided a boost to profits. However, the growth rate of revenue came in at 8.3%, also an impressive result. In addition, the current consensus of analyst estimates shows that strong double-digit profit growth is expected for all of 2018. According to FactSet, the rest of the year breaks down as follows:
- For Q2 2018, analysts project earnings growth of 18.9%.
- For Q3 2018, the projection is for 21.2%.
- In Q4 2018, projections are for profit growth of 17.0%.
- For the whole of 2018, the estimate is for a total of 19.7% earnings growth.
All of this accompanies solid expectations for revenue growth this year.
So, we currently have a market whose valuation is by no means stretched based on the five-year average p/e, and expectations for strong revenue and earnings growth for the remainder of the year.
Beneath the top-line numbers it gets a little more complex
Beneath the top-line numbers it gets a little more complex.
There are 11 sub-sectors (sectors) that together constitute the S&P 500 Index. By looking at the results and projections for each, we can look for opportunities. While we won’t provide a comprehensive review of each of the 11 here, a few sectors have shown noteworthy results.
The Energy sector enjoyed the highest growth in profits of the 11 sectors in Q1 at 96.5%1. While this seems very attractive, we must look at the fact that this sector has faced severe challenges for the past several years, and by comparison of their long-term average, last year’s results were quite low. So, as prudent investors we must weigh the growth of profits against the current valuation in the sector and make reasonable judgements.
The Information Technology sector, a perennial over-weight for some, showed strong profit growth in Q1 2018 at 33.6%1. In fact, this sector reported the highest percentage of its constituents delivering results that beat estimates in Q1.
Financials reported growth in profits of 26.8% in the first quarter amid slow revenue growth, and aided meaningfully by the passage of the tax bill.
These examples are not intended as recommendations for investment, but rather provided to highlight some of the sectors that reported interesting results. At Atlas, we look much further into each sector’s results to make prudent decisions on investments for the future.
Interestingly, we have recently heard from several of our clients that they have concerns about current market levels, and are of the belief that some sort of correction is imminent. While we are cautious at all times about the prospect of negative volatility, we think that the strong results reported for the first quarter, along with projections for solid earnings growth for the remainder of 2018 and into 2019 provide much greater fundamental support for current equity market levels.
It seems that there’s always something to temper investors’ enthusiasm at positive news
So, if strong earnings were reported for the first quarter, why then didn’t the stock market have a run-up? Well, it seems that there’s always something to temper investors’ enthusiasm at positive news, and this time is no different. While profit results were very positive, we still have the Fed firmly in a rate hiking phase, instability in international trade policy, and the concern that earnings and margins may have peaked. As a forward-looking mechanism, the stock market tends to discount events in the future, not react to past accomplishments. This may be why we saw such a strong market in 2017. But, as of the time of this writing, we’ve seen a strong couple of months. We remain cautiously optimistic that the second half of 2018 could see solid returns, albeit in the context of increased overall volatility.
Clearly, questions remain about the future direction of fiscal, monetary, and trade policies. These could have substantial effects on the future of stock valuations, and by no means are we unaware of their importance. In the current environment, with daily headlines increasing short-term volatility, it is quite possible that events could shift that might change our outlook. However, we think that recent market valuations are reasonable, and to the extent that current projections are realistic, we’re encouraged with the 18-month outlook.
As always, if you have any questions about this update, or any other financial planning topic, please feel free to contact your Atlas Wealth Management Advisor.