by Wolf
Richter • Jul 10, 2017
It will be ignored until it’s
too late.
Everyone who’s watching the
stock market has their own reasons for their endless optimism, their
doom-and-gloom visions, their bouts of anxiety that come with trying to sit on
the fence until the very last moment, or their blasé attitude that nothing can
go wrong because the Fed has their back. But there are some factors that are
like a tsunami siren that should send inhabitants scrambling to higher ground.
Since July 2012 – so over the
past five years – the trailing 12-month earnings per share of all the companies
in the S&P 500 index rose just 12% in total. Or just over 2% per year on
average. Or barely at the rate of inflation – nothing more.
These are not earnings under
the Generally Accepted Accounting Principles (GAAP) but “adjusted earnings” as
reported by companies to make their earnings look better. Not all companies
report “adjusted earnings.” Some just stick to GAAP earnings and live with the
consequences. But many others also report “adjusted earnings,” and that’s what
Wall Street propagates. “Adjusted earnings” are earnings with the bad stuff
adjusted out of them, at the will of management. They generally display
earnings in the most favorable light – hence significantly higher earnings than
under GAAP.
This is the most optimistic
earnings number. It’s the number that data provider FactSet uses for its analyses, and these
adjusted earnings seen in the most favorable light grew only a little over 2%
per year on average for the S&P 500 companies over the past five years, or
12% in total.
Yet, over the same period, the
S&P 500 Index itself soared 80%.
And these adjusted earnings
are now back where they’d been on March 2014, with no growth whatsoever. Total
stagnation, even for adjusted earnings. And yet, over the same three-plus
years, the S&P 500 index has soared 33%.
This chart shows those
adjusted earnings per share for all S&P 500 companies (black line) and the
S&P 500 index (blue line). I marked July 2012 and March 2014 (via FactSet, click to enlarge):
Given that there has been zero
earnings growth over the past three years, even under the most optimistic
“adjusted earnings” scenario, and only about 2% per year on average over the
past five years, the S&P 500 companies are not high-growth companies. On
average, they’re stagnating companies with stagnating earnings. And the
price-earnings ratio for stagnating companies should be low. In 2012 it was
around 15.5. Now, as of July 7, it is nearly 26.
In other words, earnings
didn’t expand. The only thing that expanded was the multiple of those earnings
to the share prices – the P/E ratio. Such periods of multiple expansion are
common. They’re part of the stock market’s boom and bust cycle. And they’re
invariably followed by periods of multiple contraction.
How long can this period of
multiple expansion go on? That’s what everyone wants to know. Projections
include “forever.” But “forever” doesn’t exist in the stock market. The next
segment of the cycle is a multiple contraction.
The 10-year average P/E ratio,
using once again the inflated “adjusted earnings,” not earnings under GAAP, is
16.7, according to FactSet. This includes two big stock market bubbles, the one
leading up to the Financial Crisis, and the current one, but it includes only
one crash. This imbalance skews the results. Two complete cycles would bring
the average substantially below 16.7.
Nevertheless, even getting
back to a P/E ratio of 16.7 for the S&P 500, when the current PE ratio is
25.6, would signify either miraculously skyrocketing earnings or a sharp
contraction of the market. The first option is a near impossibility. And the
second option?
Markets overshoot, which is
what reversion to the mean entails: the average isn’t going to be the floor!
And that’s why this type of unsustainably high earnings-multiple is like a
tsunami siren where the arrival time of the tsunami remains unknown – and
that’s why it is ignored until it’s too late.
Already, bankruptcies are
surging as the “credit cycle” exacts its pound of flesh.
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