How the market goes in 2020 will be heavily impacted by earnings. So, how are earnings looking?
As I write Tuesday morning, U.S. stocks are in full rally mode.
We saw big overnight gains in Europe and Asia … the People’s Bank of China plowed another $71 billion into its financial system … and the rate of Coronavirus increase has slowed from last week.
U.S. markets are breathing a collective sigh of relief.
So, what happens from here?
Well, expect the bull market to continue … if companies can deliver on earnings.
That’s a key takeaway from Neil George’s latest issue of Profitable Investing.
Of course, at the end of the day, earnings are what it’s all about — we buy shares of ownership in companies because we want to receive a pro rata portion of that company’s earnings … which we hope will increase.
So, when we look at various market indicators, or news events, or sentiment surveys, while they can be interesting to evaluate at face-value, eventually, we have to take things one step further and ask “so, what does this mean for earnings?”
For example …
Will U.S. consumers continue feeling confident in their personal finances, leading them to open their wallets — and how will that support corporate earnings?
Will exogenous events like the Coronavirus be resolved, or will they grind trade to a halt, resulting in fewer sales — which would materially curb corporate earnings?
Will potential trade deals (like USMCA and U.S.-China Phase 1) and geopolitical considerations (like Europe’s proposed digital tax plan), affect sales for major U.S. companies — and how will that impact corporate earnings?
Last week, in Neil’s most recent issue of Profitable Investing, he took a 30-thousand-foot view of the U.S. markets — a bit of a “health diagnostic” on our current bull market. And what he found is that, at the end of the day, it all points back to whether profits are rising or falling.
So, in this Digest, let’s recap how Neil is viewing the markets. And then we’ll take a look at how the numbers are shaping up here at about the midway point of Q4 earnings season.
***The overall snapshot of the economy
Let’s begin high-level. As we look at the U.S. today, what are the major indicators saying about overall strength or weakness?
Here’s Neil for broad context:
The U.S. economy remains in growth mode. The gross domestic product (GDP) should be running at 2.2%, with personal consumption gaining 3.2%.
This comes with an unemployment rate at a mere 3.5% and wages gains on average of 2.9%. That’s well above the inflation rate, as measured by the core Personal Consumption Expenditure (PCE) of only 1.61%.
Forward-looking data show consumers should continue to spend. The Bloomberg Consumer Comfort Index, which is my favorite predictive indicator of households’ ability and willingness to spend, is at a multi-year high of 66.0.
Neil goes on to note how forward-looking business surveys, such as the Markit Compositive PMI Index, are getting back to optimistic levels (the Markit index indicates buying to fulfill expected orders).
He also points toward bullish expectations from C-level executives, as well as the progress on two major trade deals — the United States-Mexico-Canada Agreement (USMCA) and the Phase I China Trade Agreement.
So far, so good.
But, as we noted earlier, after we evaluate each of the metrics/dynamics/news events at face value, we then have to ask the follow-up question — what does it mean for earnings?
Back to Neil:
But to make this work for the stock market, companies need to deliver more sales and earnings. If the companies that drive the S&P 500 don’t deliver, then the P/E and P/S ratios will make the index expensive and not worth our investing dollars.
***On that note, where are U.S. stock valuations right now?
A quick primer for any readers who are less familiar …
When trying to decide whether any particular stock, or even a broad stock market, is offering a good value or not, investors often look at “valuation multiples.”
Basically, a multiple is telling you what you’re paying per unit of some measured metric.
For example, one of the most-often cited valuation metrics is the price-per-earnings multiple (P/E). We have two variables — a stock’s price per share and a stock’s earnings per share.
Basically, P/E measures how much an investor is willing to pay per unit of a company’s earnings.
Multiples like the P/E ratio have long-term averages. For example, the S&P’s long-term average P/E is almost 16.
Below you can see it rising and falling over the years as investors have been willing to pay more, and less, for each unit of earnings at various points in time.
Source: Multpl.com
So, when an investor is trying to determine whether a stock is an attractive “buy” or not — he/she can compare the current multiple to the long-term average multiple.
With that behind us, back to Neil:
… the U.S. economy and markets have a lot going for them, even after the big performance in 2019 and the continued progress since 2009 to date. But the valuation of the S&P 500 Index is quite high.
The P/E of the S&P 500 is at 22.19, the P/S is running at 2.24 and the P/B is running at 3.72 — all of which are around recent highs for valuations.
Given the context we established a moment ago — specifically for the P/E ratio — you can see how a reading of 22.19 is high relative to its long-term average of about 16.
Also, Neil noted how P/S (price to sales), and P/B (price to book) are also around recent highs.
But valuations aren’t the only things that have been climbing.
Back to Neil:
… over the past three years, the underlying earnings of the S&P 500 have been gaining at a compound annual growth rate (CAGR) of 10.3%.
Sales have been gaining at an annual rate of 5.9% for the same time period.
And businesses have been building net assets to grow book value at an annualized rate of 5.2%.
This means that while the price of the S&P 500 is climbing, the underlying values are also on the rise.
Of course, if the P/E multiple is rising (as well as the other multiples), that means prices have been climbing faster than earnings. And if valuations are high, does that mean today’s market is comparable to past bubble-markets that ended in a crash?
***Are we mirroring the bull of 1987 – 2000?
At this point in his issue, Neil brings up the bull market that ran from the late 80s through the dot-com bubble of 2000. Might it be instructive to compare that bull to the one we’re in today?
In this discussion, Neil notes a key difference between them …
Specifically, valuation multiples got way out of hand in the 2000 bull. In other words, prices — the “P” part of the P/E ratio — were climbing far higher, far faster than earnings — the “E” part of the P/E ratio.
As a result, the P/E multiple skyrocketed during that period (you can see this in the historical P/E chart above).
Back to Neil:
… the key was that earnings weren’t rising. And expectations weren’t there for improvements.
This time around, the S&P 500 still represents value, but only if sales rise and earnings rise in the coming quarters of 2020.
So, if we want to prevent a run-up in valuation like the one that preceded the crash in 2000, we need earnings to do a better job of climbing relative to prices.
***With that in mind, where have earnings been coming in now that we’re about halfway through the Q4 earnings season?
FactSet is the go-to company for earnings data.
Last Friday, it reported that 45% of the companies in the S&P 500 have reported actual results for Q4 2019. As was expected, earnings have come in below five-year averages.
However, of the companies that have reported, 69% have reported EPS above estimates. In aggregate, companies are reporting earnings that are 4.1% above estimates.
Here’s a snapshot of earnings results so far, broken down by sectors.
(By the way, notice the left column “tech” — with 90% “above” earnings, which supports our Digest from yesterday about tech preeminence.)
Source:FactSet
If we look ahead to the coming quarters, FactSet reports analysts expect earnings growth of 4% to 6% for Q1 2020 and Q2 2020.
And if we look at the entire year, things improve even more.
From FactSet:
The estimated (year-over-year) earnings growth rate for CY 2020 is 9.6%, which is above the 10-year average (annual) earnings growth rate of 9.1%.
All 11 sectors are projected to report year-over-year growth in earnings. Five sectors are predicted to report double-digit growth, led by the Energy, Industrials, and Materials sectors.
Back to Neil for the takeaway:
If the reality of these compiled projections come through, then the S&P 500’s growth should be sustained. But if the results don’t unfold as expected or we get pessimistic outlooks like what we experienced into the fourth quarter of 2018, then things might get dicey.
Right now, there’s the economic and business data to support better values.
As we stand today, earnings projections suggest this bull market has more room to run … as long as the earnings numbers hold up.
So, keep your eye on how earnings come in over the year. If they rise too little relative to prices, valuation multiples will continue expanding, getting us closer to historical bubble territory. But if they rise as is expected, or above expectations, it will create more room on a “fundamentals” level for this bull to keep going.
We’ll keep you up to speed here in the Digest.
Have a good evening,
Jeff Remsburg
