The price-to-earning ratio is the most widely used gage of stock market valuation: how expensive or cheap the market is relative to earnings. The S&P 500 is currently trading at around 18.6 times its trailing 12-month earnings. At model Capital, we find that historically, the trailing P/E Ratio has a significant effect not only on long-term (2-year) expected equity returns, but also on near-term (6-month) returns.
At 18.6, the current P/E is above 5-year average of about 16. This is but one of multiple factors at play, but if taken in isolation, this factor has a significantly negative impact on expected near-term return for the S&P 500 as part of our tactical investment models. We also track it closely during quarterly earnings reporting seasons – it often shifts quickly as growing corporate earnings are reported for a quarter. The P/E Ratio often improved during earnings seasons in previous years as EPS grew strongly.
Not so this year – adjusted earnings were essentially flat in 1H-2015. After declining in Q2 (-0.7% YoY), earnings are expected to decline again in Q3 by 4.6% YoY, according to Factset (see chart). Reported earnings typically beat estimates by an average of 3% to 4%; but, if reported earnings do in fact drop in Q3, it would be 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.
The fallout from commodity price debacle continues to haunt Energy and Materials sectors. But companies in other sectors have also reported mixed Q3 results, with a few notable misses. Alcoa (AA) opened the earnings season on a weak note again this quarter, reporting $0.07 EPS and missing the $0.13 analyst estimate. Wal-Mart Stores (WM) missed the estimate for Q3 and said that it expects next year’s earnings to decline by 6% to 12% – very unusual for the retail giant. Results were mixed in the financial sector, with JP Morgan Chase (JPM) and Goldman Sachs (GS) missing the street’s expectations due to weak trading results, while Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C) beat expectations.
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Model Capital Management LLC is a tactical investment manager. Please review the following pages for more information on Model Capital’s approach to tactical investment management and our tactical management strategies.