Earnings Are Cheaper Than They Were One Year Ago, But Are Stocks A Bargain?
By: Sasha Kostadinov, CFA
Not including dividends, the stock market has returned about zero over the last year even though earnings are higher. By definition, investors have repriced earnings lower, which is to say that they value the same level of earnings less than before.
This can be seen clearly by comparing the price-to-earnings ratio of the average stock today to a year ago. If you exclude companies that are losing money, the average stock today is trading at 21.0x trailing operating earnings per share. A year ago, the average stock was trading at 25.2x trailing operating earnings per share. That is a 17% decline in the price of earnings.
Looking at the median, the decline is even greater. The median is the mid-point, meaning that half of the numbers are above it and half are below it. The median is a similar statistic to the average, but it is not influenced by extreme values as much. One year ago, the price-to-earnings ratio for the median stock was 20.5x. Today, it is 15.9x. That is a 22% decline in the price of earnings.
Over this same period, the average trailing operating earnings per share increased 9%. Excluding companies that lose money, the average trailing operating earnings per share increased 12%.
Why Are Earnings Worth Less Today?
As usual, there are a number of factors that explain why investors value earnings less today than they did a year ago, but there are two fundamental reasons for the lower repricing of earnings today: (1) future earnings growth is expected to slow and (2) last year earnings were valued higher than usual.
Future Earnings Growth Is Expected To Slow
When investors buy or hold stocks today, they mainly do so with an eye to future earnings. Trailing earnings growth benefitted from the reduction in the federal corporate tax rate, which is now behind us. Over the last year, pretax profit growth has been slower than after tax profit growth. For the average company, pretax profit increased 6% over the last year. For the median company, it increased just 2%.
In addition to already slow pretax income growth, an increasing number of economic and financial indicators are pointing to slower economic growth ahead. In fact, without intervention from the Federal Reserve, it is possible that the United States economy could be headed for a recession. The futures market now expects that there is more than a 50% chance that the Federal Open Market Committee will lower the Federal Funds rate in July. Should the Fed act, growth expectations could improve.
However, investors also are concerned about the impact of international trade tariffs, which act as a tax on businesses and consumers in the United States. Economists have calculated that should all of the tariffs remain in effect they will more than completely undo the benefits of the Tax Cuts and Jobs Act that benefitted corporate earnings and the economy in 2018. Should the tariffs remain in place for long, they could offset the impact of interest rate cuts.
Last Year Earnings Were Valued Higher Than Usual
The price-to-earnings ratio of the stock market peaked during the first quarter of 2018 as investors repriced earnings higher in anticipation of the benefits they expected from lower federal taxes. At its highest point, the price-to-earnings ratio got about 20% higher than its 25-year average. Economic data in 2018 was uniformly solid and improving until late in the year, justifying investor bullishness. For instance, in August 2018 the National Association of Purchasing Managers Index was at a 14-year high. Today, it is below its 20-year average.
All told, this has translated to a lower risk appetite for investors. One key figure we look at to measure risk appetite is the implied equity risk premium (ERP). This is essentially a measure of how much added return investors demand from stocks over the yield on risk free treasuries. In early 2018 at the same time investors were expecting high future earnings growth, the ERP was near post financial crisis lows (sub 5%). Today, even as growth expectations have fallen materially, the ERP is close to 6% signaling that investors are demanding higher expected future returns in the face of greater uncertainty.
Are Stocks A Bargain?
The answer depends on the future actions of the Federal Reserve and the parties involved in international trade negotiations. The stock market today is trading in line with its price-to-earnings ratio average over the last 25 years. The United States economy grew in the first quarter of 2019 and likely also will grow in the second quarter. Economists have lowered their growth forecast for the second half of the year given current trends in place. If the Federal Reserve supports the economy by lowering interest rates and the international trade negotiations are settled, we expect that growth forecasts would improve and investors would reprice earnings higher. To the extent that does not happen, investors may value earnings even lower than today. Should we experience a recession, corporate earnings would decline, which would be another significant factor weighing on market returns.
Risks in the market can create opportunities. At Shaker Investments we focus on the stocks of companies that are addressing long term secular opportunities that transcend the business cycle. Although the share prices of these stocks are not immune to fluctuations in the market, their business opportunities do not vanish with lulls in the business cycle.
If you have questions about this commentary or any other matter concerning your portfolio, please feel free to contact us via email or telephone. We would be glad to go into further detail with you.