Trampled Under Foot: Earnings Estimates Crushed; But Not Stocks
- Valuation doesn’t matter until it does.
- The trend in earnings growth has dipped into negative territory—like in 1986 when oil prices also tanked.
- But recession risk is low … and so is the earnings expectations bar.
History shows that market valuation doesn’t necessarily matter…until it does. The tough part is trying to gauge what might trigger the tipping point. Global monetary policy conditions remain very equity market friendly; but pending US rate hikes will likely change the backdrop, and today’s weak earnings growth could regain the spotlight.
Uncertainty on the rise
Although global monetary policy suggests still-ample liquidity, policy uncertainty is on the rise, partly due to global monetary policy divergence, and the pending first Federal Reserve rate hike.
The Economic Policy Uncertainty Index shown in the chart below measures three factors: newspaper coverage of policy-related economic uncertainty, the number of federal tax code provisions set to expire in future years, and the level of disagreement among economic forecasters. This uncertainty is historically inversely correlated with forward price-to-earnings ratios (P/Es). But as you can see below, policy uncertainty has been rising, yet P/Es (inverted) have also been rising.
Source: FactSet; Scott Baker, Nicholas Bloom and Steven J. Davis at www.policyuncertainty.com, as of February 27, 2015. P/Es based on forward 12-month consensus operating earnings.
Rising P, falling E
A P/E ratio obviously has two components and lately, the price (P) of the S&P 500 has been rising, while earnings (E) expectations have been falling. The result is a P/E—on either trailing or forward earnings—that is above long-term median levels.
Earnings estimates have been coming down fairly sharply courtesy of the strong US dollar, low oil prices (for energy companies), and recently-rising wage expenses. In fact, the downturn in forward earnings-per-share growth (in six-month annualized change terms) for the S&P 500 has moved into negative territory, as you can see in the chart below. This type of deterioration rarely occurs in non-recessionary times.
Source: Bureau of Economic Analysis, FactSet, as of February 27, 2015.
Our data only extends back to 1997, but for what it’s worth, there was also a dip into negative territory for forward earnings growth in 1991 (recession) and in 1986 (no recession).
No recession risk signaled
I don’t think the US economy is at risk of a recession, even with earnings growth having dipped into negative territory. The 1986 experience may be instructive given the similarity of crashing oil prices; and the fact that in both cases, the plunge was largely supply-driven.
That said, forward earnings are falling more today than in 1986 because energy profits now contribute nearly twice as much to overall earnings as they did in the mid-1980s. But today’s earnings have also been weighed down by the stronger dollar—foreign exposure now accounts for nearly half of overall S&P earnings, and carries above-average margins. The dollar is appreciating strongly today, while it was falling in 1986.
This cycle has been unique relative to history as record-high profit margins have driven a greater-than-normal share of earnings growth. That said, margins are likely to come under pressure if wage growth continues to accelerate and/or if the dollar continues to strengthen.
Impact of yield curve and inflation
The flatter Treasury yield curve is also signaling the market is concerned about the economy’s ability to handle higher short-term interest rates; which could put downward pressure on P/Es.
Longer-term interest rates have been held down by falling inflation and extremely low global interest rates. We just saw the first negative headline Consumer Price Index (CPI) print since the Great Recession, and this can come into play as it relates to valuations.
Below, you will see two charts; the first of which is a long-term look at forward P/Es for the S&P 500. At first blush, there is nothing terribly alarming about this picture, as valuations are not far above the long-term median. But, inflation matters for valuations as you can see in the accompanying table below the chart.
Source: Bureau of Labor Statistics, FactSet, as of February 27, 2015. P/Es based on forward 12-month consensus operating earnings. Inflation is y/y % change based on CPI.
As you can see above, the market has a “Goldilocks” range (1-3%) for inflation during which times P/Es have been highest historically. But it’s a bell-shaped curve in that the market not only dislikes significantly higher inflation; it also dislikes the risk of deflation. That’s why you see the lowest P/E ratios historically occur when inflation is either too hot or too cold.
The hope—and likely reason why the market is, so far, looking past the drop in inflation—is that this deflationary episode will be short-lived and has been largely driven by the >50% peak-to-trough decline in oil prices.
Companies slash forward guidance
Bespoke Investment Group (BIG) calculates the “guidance spread” each quarter, which measures the difference between the percentage of companies raising guidance and lowering guidance; so when the number is negative, more companies have lowered guidance than raised guidance. The spread for the most recent quarter came in at a “ridiculously low” -9.4 percentage points. That was the lowest guidance spread since the final two quarters of 2008, at the end of the financial crisis.
The pace of earnings estimate cuts by Wall Street analysts and companies has been well sharper than the norm, suggesting the bar has now been set so low as to make it easier to hurdle. That’s what investors can hope for heading into the next earnings season; but the risk around earnings and valuation is unquestionably higher than it’s been in some time.
(c) Charles Schwab