The price-to-earning (P/E) ratio is the most widely used gauge of how expensive or cheap the market is. As of Nov 6, the S&P 500 was trading at 19.7 times its trailing 12-month earnings. Yes, 19.7, not 16.5 or so that some people use based on expected forward earnings that are notoriously optimistic. Now, 19.7 is well above historical averages of about 15-16. And especially surprising is such high valuation in the face of significant headwinds for future U.S. corporate earnings growth, including global economic slowdown (both the IMF and OECD repeatedly lowered growth projections), the rout in commodity prices and the resulting disinflation, and the high dollar.
In fact, the S&P 500 earnings are already declining. Adjusted earnings were essentially flat in 1H-2015. After declining in Q2 (-0.7% YoY), earnings declined again in Q3 by 2% YoY, according to Factset (see chart). This is the first decline for two consecutive quarters since 2009. I should also note that these headline earnings that most market participants follow, are adjusted to exclude “extraordinary items”. Net GAAP earnings dropped by 14% YoY in 1H-2015 and are expected to drop significantly again in Q3.
To be sure, the drop in earnings is driven primarily by 60% YoY decline for the Energy sector. But weakness is not limited to the Energy and Materials sectors. Industrial sector earnings (-3.2%) are under pressure due to both reduced demand for equipment and the strong dollar, and Consumer Staples (-1.0%) also reported YoY earnings decline in Q3.
In my view, a downward adjustment in equity prices to a more-reasonable valuation is a question of when, not if. Historically, above-average P/E multiples persisted for years (e.g., late-1990’s, 2006-07) but this usually occurred in periods of growing earnings. According to this chart from Factset, the last time earnings started sustainably declining was in 2008, and equities adjusted rather quickly.
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