Q3 Earnings Wrap-Up: No Matter How You Slice It, the S&P 500 Is Overvalued

With 96% of the S&P 500’s stocks having reported last quarter’s results, the third-quarter earnings season is coming to a close. And … they weren’t great. Overall, income fell more than 14% on a year-over-year basis during Q3, marking the fourth straight quarter of declining earnings and the worst season since 2009.

Q3 Earnings Wrap-Up: No Matter How You Slice It, the S&P 500 Is Overvalued

There’s one overarching reason for most of the earnings contraction, of course — the energy sector’s impact. With crude oil prices being held down all year long (with prices held to sub-$50 levels since August), oil companies’ earnings have simply been shattered.

Regardless, the market as a whole still has to absorb the net losses taken by the energy sector, and a few themes are prevalent when one takes a closer look at the third quarter’s earnings figures.

Third-Quarter 2015 Earnings

As of late last week, the S&P 500 was on pace to earn $25.44 per share for Q3 (Excel). That’s far less than the $29.60 the index earned in the third quarter of 2014, before weakening oil prices had a chance to take a serious toll. And it’s far less than the $28.55 analysts had collectively expected the S&P to earn last quarter.

That sizeable pullback in YoY income presents investors with something of a conundrum: Do we dismiss the adverse impact the energy sector made on the market’s overall earnings, knowing those results are statistical outliers and (hopefully) aren’t a permanent drag? Or should traders reprice the broader market in fear that the energy sector is poised to take losses indefinitely as a results of unusually cheap oil?

The answer, as usual, is somewhere in the middle.

To fully appreciate what’s wrong with Q3 earnings results (as well as what’s encouraging), one has to first drill down into each sector’s results to find the weak link.

On the table below, it’s not hard to find.

S&P 500 Q3-2015 Earnings, by Sector

The S&P 500 Energy Sector Index swung from a solid profit a year ago to a sizeable loss on a YoY basis. For the S&P 500, that translated into a difference of nearly $5 worth of profit last quarter.

In other words, had the energy sector simply earned in Q3 of 2015 what it had earned in Q3 of 2014, the S&P would have earned $30.40 last quarter. That figure would have not only been a record, but would have extended a trend that’s been in place for a few years now.

In that light, it’s much easier to remain excited about stocks again … if you believe that oil will rebound sooner than later.

S&P 500 Valuation Is Pressured

There’s always an element of danger in playing the “what if” game with the market. In this case, there’s a good chance that, had oil prices not imploded, it could have worked against the earnings growth we saw from the discretionary sector.

Still, we have to stop analyzing and start applying ideas at some point; so in the name of simplicity, we’ll just keep the energy sector in its vacuum to determine the market’s actual and hypothetical value had oil companies been operating in a normal environment.

Simply put, the S&P 500 is valued at a trailing price-to-earnings of 20.06. Had crude oil prices not crushed the energy sector’s income during the third quarter, the S&P 500 would be valued at 19.15.

One could rationally argue that the income pressure that pulled the energy sector’s earnings into the red last quarter actually developed as a headwind in the fourth quarter of 2014, making the last four quarters’ overall earnings uncharacteristically low, thus making that adjusted trailing P/E of 19.1 still too high.

But, even normalizing the energy sector’s earnings since Q4 of 2014, the S&P 500 would still be valued at a trailing P/E of around 18.0, which is still on the upper end of what the market can support for the long haul.

Too Much Optimism

With all of that being said, perhaps what’s most concerning about third quarter’s marketwide earnings results isn’t the recent history and the market’s subsequent valuation. Rather, it’s the current expectations for earnings growth in 2016.

S&P 500 Earnings Trend, Outlook
Click to Enlarge 
As of the latest look, Standard & Poor’s says the S&P 500 is projected to boost its bottom line to $126.76, up 18.8% from what’s apt to be a bottom line of $106.71 this year.

That’s a big leap forward even if crude oil rebounds and the U.S. dollar cools off. If crude and the greenback don’t reverse course, however, achieving those earnings targets would be miraculous.

For perspective, the S&P earned $113.01 in 2014, before low oil prices became a major problem. These pros are saying earnings will be 12% better next year than they were last year. That’s big, and as the adjacent chart shows, it’s also out of the S&P 500’s long-term earnings growth trend.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/11/sp-500-earnings-q3/.

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