Tag Archives: price to earnings multiple

Peak Earnings?

With the S&P500 down 9% off its high this month after last week, the question everybody is asking is whether this is a buying opportunity or the beginning of a new phase in the market. I have no idea. Nobody really does. I suspect this week will be bumpy but will rally off Fridays’ lows as there is some cheap names who have been hit hard. I have been modestly dipping my toe in on some names but am waiting before making any big moves. I hope to post on a few of the stocks regularly mentioned in this blog in the coming weeks.

The underlying concerns about the global economy and trade, the impact of US rate increases and quantitative tightening, Italy, to name but a few, have been and continue to be real issues to consider. The fact that the market has turned on a penny and is now all worried about the issues it shrugged off a few weeks ago is, well just how markets are!

What I do know is that this bull market has all been about earnings and margin growth, nothing else matters. So, I took the latest operating EPS and sales estimates for 2019 from S&P, extrapolated them into 2020, assuming a modest slowing of the EPS growth. These operating margin figures and assumed sales figures form the basis of Scenario 1. Stressed operating margin and sales formed the basis for Scenarios 2 and 3, with Scenario 2 falling back to the 2013-17 average operating margin of 9.5% and Scenario 3 falling more severely to the 2008-18 average of 8.75%. The graph below shows the operating margin assumptions in a historical context for each scenario.

click to enlarge

Assuming a price for the S&P500 as per Friday’s close of 2,659, the EPS figures with respective trailing and future 12-month PEs are as per the graphs below.

click to enlarge

click to enlarge

click to enlarge

So, if the current operating estimates for 2019 stand up and continue into 2020 as per Scenario 1, then I would say the current dip is a buying opportunity with a forward 2019 and 2020 PE of 15 and 14 respectively. If, however, you feel that we have reached peak earnings and a modest enough EPS retrenchment over 2019 and 2020 is likely as per Scenario 2, then the current S&P500 level looks vulnerable to further downside as the implied forward PEs of 17.5 and 18.7 for 2019 and 2020 look rich in a downward trending EPS environment. If, as per Scenario 3, the EPS retrenchment is more severe, then we are in for a very bumpy ride with another 15% to 25% downside possible.

To state the obvious, the current market focus is all about the earnings outlook for 2019 and 2020. The mid-terms over the next few weeks will be another factor to consider. It will be interesting to see if the market focus moves away from the economic prospects over the next few years and more towards 2018 bonuses and end of year window dressing as this quarter progresses!

Sell in May and go away…

This week has been a volatile one on the markets with much of the week’s losses being regained after a “goldilocks” jobs number on Friday. Janet Yellen chipped in with the statement that “equity market values at this point generally are quite high” which resulted in the debates about market valuation been rehashed on the airwaves through the week.

My thoughts on the arguments were last aired in this post. I believe there is merit to the arguments that historical data needs to be normalized to take into account changes in business models within the S&P500 and the impact of changes in profit margins. Yield hungry investors and the lack of alternatives remain strong supports to the market, particularly given the current thinking on when US interest rate rises will begin. Adjustments on historical data such as those proposed by Philosophical Economics in this post make sense to me (although it’s noteworthy he concludes that the market is overvalued despite such adjustments).

Shiller’s latest PE10 metric (adjusted for inflation by the CPI) is currently over 27, about 38% above the average since 1960, as per the graph below.

click to enlargeCAPE PE10 1960 to May2015

I tend to put a lot of stock in the forward PE ratio due to the importance of projected EPS over the next 12 months in this market’s sentiment. Yardeni have some interesting statistics on forward PE metrics by sector in their recent report. Factset also have an interesting report and the graph below from it shows the S&P500 trading just below a 17 multiple.

click to enlargeForward 12 month PE S&P500 May2015

Recently I have become more cautious and the past week’s volatility has caused me to again review my portfolio with a ruthless eye on cutting those positions where my conviction against current valuation is weakest. Making investment decisions based upon what month it is can be justifiably called asinine and the graph below shows that the adage about going away in May hasn’t been a profitable move in recent years.

click to enlarge5 year S&P500 go away in May

However my bearishness is not based upon the calendar month; it’s about valuation and the nervousness I see in the market. To paraphrase a far wiser man than me, all I bring to the table is over 20 years of mistakes. Right now, I would far rather make the mistake of over-caution than passivity.