Chart of the week – The price of earnings

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With quarterly reporting by US S&P 500 companies well under way, we look at changes in earnings expectations and their impact on the equity market and assess whether there are other factors that set the course for share prices rather than the outlook for profits.

Earnings expectations took a backseat…

For all the concerns at the end of 2018 about a slowdown of global growth and its impact on corporate earnings, our model suggests changes in profit expectations were not the key driver of the market’s moves.

From the S&P 500’s peak at the end of September 2018 to the bottom at the end of December, the biggest factor was the rise in the equity risk premium, followed by changes in expectations for shareholder pay-outs. Investors were evidently too optimistic about the prospects for earnings growth last autumn and had to revise their expectations lower.

…and have lingered there

Worryingly, those expectations have yet to turn around convincingly. The expected earnings growth rate has more than halved since the autumn of 2018 and the recent modest improvement in the outlook has been driven mostly by the energy sector on the back of higher oil prices (see exhibit 1).

It is worth noting that while interest rates were a factor in the initial fall in the market, the impact had reversed by the end of 2018. However, it has been mostly the fall in the equity risk premium that has supported the market’s recovery, while earnings growth estimates have been a drag.

Chart of the week – The price of earnings

Less room for upside

The latest S&P 500 earnings season has gone better than expected. With first-quarter earnings growth beating the admittedly lower estimates, we expect analysts to revise up their forecasts soon. Will this be enough to give the market a notable leg-up? And if not, what can propel the market?

Earnings expectations further out never fell as much as estimates for the near term, so there is less room for a rise and support from that side. We believe interest rates are unlikely to change significantly any time soon, while at the same time, equity valuations [*] now look rich after they rebounded.

It seems unlikely that we will see another drop in the equity risk premium commensurate with the move since December. Markets may still ‘grind up’, but that would likely come from a reversal of the negative earnings revisions seen over the last several months.

[*] We believe the price/earnings ratio as a measure of equity valuations should be interpreted with caution, particularly after a material shift in bond yields. A persistent reduction in yields typically translates into a persistently higher P/E, inflating valuations. As long as yields stay lower (because the bonds bought by the world’s central banks remain on their balance sheets), they support valuations. As a result, investors should not compare current P/Es and those observed before central banks started buying bonds. Until the views of investors in safe assets – reflecting their concerns over the outlook – and those of the more sanguine investors in risk assets align, low yields can be expected to support the equity risk premium. In other words, yields will continue to point to sustainably higher P/Es.

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

Daniel Morris

Senior investment strategist, CFA charterholder

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