Can US Stock Investors Rely on Earnings Growth?

With US equities trading at relatively high valuations, earnings growth will be essential for investors to generate returns in 2020. That’s a tall order in today’s environment. Finding standout companies with sustainable growth potential will be especially important.

There’s been plenty of good news for investors in early 2020. The US Federal Reserve continues to maintain a highly accommodative monetary policy. Trade deals are now in place with China, Mexico and Canada. Congress has reached a budget deal. Even amid the highly charged politics of an election year and an impeachment trial, the macroeconomic backdrop is keeping investors upbeat.

Revisiting Market Valuations

But is the good news already priced into the market? It certainly feels that way with the S&P 500 trading above 18.4 times operating earnings estimates for 2020, through January 31 (Display, below). This is well above the historical average of about 16 times earnings over the past 30 years.

However, equity valuations shouldn’t be viewed in a vacuum. The current interest-rate environment makes a difference for stock valuations. Today, the 10-year US Treasury yield is under 2%, which is well below the long-term average of 4%. When rates are lower, equity valuations should be higher, as investors discount future cash flows at a lower rate, which supports higher stock prices.

Seen in this light, we don’t think current valuations are a risk. Of course, if 2020 earnings falter or inflation picks up meaningfully, we would need to reassess. However, assuming current conditions prevail, additional price/earnings multiple expansion is doubtful, and equities are only likely to rise further from today’s valuations if earnings advance.