The Long Slog Toward a Cheaper Market

Over time, earnings and stock prices move together. The short term is more of an educated guess that is probably best left to technical analysis. With earnings season wrapping up, it makes sense to look at where we’ve been, where we are, and where we may go as we move into 2013.

The chart below plots the S&P 500 against two different measures of earnings, “operating” and “as reported.” There are two important takeaways from the chart. First, as stated above, earnings and the market generally move together. Second, the market is getting cheaper, and it has been doing so for over a decade.

Chart 1: Earnings Has Gained Ground on Prices
S&P 500 and EPS: Q4 1998 – Q4 2013(est.)
earnings gained ground on prices

In 2000, the S&P 500 traded near 1,500, and earnings were about $56, giving us a P/E ratio of about 27. In 2007, the market was again near 1,500. This time earnings were near $85, producing a P/E of about 18. This year, the market sits near 1,400, but now earnings should be closer to $90 and could be over $100 by next year. This leaves us with a P/E of around 16, just about at its long-term historical average.

The next chart shows that 10-year normalized valuations for operating earnings and EPS have also been in decline. These normalized P/Es, however are still near 18 and 20 respectively. This is hardly cheap, but it is dramatically cheap compared to a decade ago when both measures of valuation were above 40.

Chart 2: 10 Year S&P 500 Normalized P/E
earnings gained ground on prices

Regardless of how we measure valuation, the market is cheaper than it was a decade ago. Even with the cheaper valuations and the fact that earnings are approaching all-time highs, the next chart gives us a bit of pause. It plots operating earnings against as reported EPS with S&P estimates out to Q4 2013. For a quick refresher, operating earnings measure exactly what it sounds like, the earnings a company receives from the basic operating activities of the business. S&P provides these estimates on a bottom-up basis. All in EPS adds or subtracts balance sheet adjustments (e.g., write-downs) that affect the income statement. Estimates are reported top-down. Operating earnings should almost always be higher than EPS, so the P/Es will be lower.

Chart 3: EPS vs. Operating Earnings (Q1 2000 – Q4 2013 est.)
earnings gained ground on prices

Going into 2013, operating earnings are expected to continue to grow. As reported earnings, however, are expected to stall. This probably means that balance sheet adjustments are becoming more likely. The last two times these two numbers diverged—2001 and 2007— the markets corrected and we went through recession.

We believe, given the short-term political uncertainty stateside and the longer-term political uncertainty in Europe, the cyclicality of earnings in the first half of 2013 will be very difficult to predict. If we get a fiscal cliff deal that meaningfully removes some of Washington’s self-inflicted macro uncertainty, earnings could be stronger than forecast. Further, P/E ratios could rise on the increased clarity. A major European breakthrough could produce a similar outcome. Broad indexes tracked by ETFs like SPDR S&P 500 (SPY), PowerShares QQQ (QQQ) and Vanguard All Country ex-U.S. (VEU) could perform quite well under this scenario.

Of course, the opposite could hold true if negotiations fail and we tumble over the cliff. It makes sense, however, to again emphasize the points of the first paragraph. Namely that earnings trends and valuation statistics are more useful in forecasting returns over long time frames (i.e., full business cycles or even decades). There is little evidence that they have any ability in predicting short-term market direction.

The opinions expressed are my own and are for informational and educational purposes only. These opinions are not a recommendation or solicitation to buy, sell or hold any security. The information in this article has been researched and is believed to be accurate, but readers should not make investment decisions solely on this information. Talk to an advisor before pursuing any investment strategy. Past performance is no guarantee of future results. Investment returns and principal fluctuate through time so shares may be worth more or less than their original cost when redeemed. Current performance may be lower or higher. Indexes are unmanaged baskets of securities that are not available for direct investment; they do not reflect the deduction of advisory fees or other investment expenses such as taxes and transaction costs.

Tags: , , ,