Tag: PE ratio

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S&P 500 earnings rise while stocks fall

96% of S&P 500 component stocks have reported earnings for Q3 2018. Including estimates for stocks that have not yet reported points to a 29% increase over earnings for Q3 in the previous year. What is more interesting is that S&P are projecting a further 2% increase for the next quarter (Q4) and 12% by Q3 2019.

S&P 500 Quarterly Earnings

Now these forecasts could be wrong but what they show is that the market expects further increases in earnings in the year ahead. Compare that to the sharp fall in earnings in Q4 2000 and in Q3 2007, before the last two major market down-turns.

Earnings growth may be slowing — it is hard to top a 29% increase —  but why the sharp downgrade?

The perceived level of risk is rising. Primarily because of the threat of a trade war with China, but also problems in the EU with Brexit and Italy. Earnings multiples are being adjusted downwards to compensate for higher risk.

S&P 500 PE of Previous Maximum Earnings

Even after the recent sell-off (orange on the above chart) the earnings multiple for S&P 500 stocks remains elevated. I use maximum 12 month earnings to-date, rather than current earnings, to remove distortions caused by temporary setbacks. The current P/E is still above the peaks prior to the October 1987 and October 1929 crashes.

The difference is that here, earnings are rising. While we cannot rule out further falls, they are unlikely to be as severe as 1987 and our expected worst case scenario is a P/E of 15. While that is harsh, it is a worst case and not the most likely outcome.

If you are a long-term investor, the sell-off should present opportunities to accumulate quality growth stocks. But patience is required. Rather get in too late than too early.

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S&P 500 Price-Earnings suggest time to buy

The forward Price-Earnings (PE) Ratio for the S&P 500, depicted by the blue line on the chart below, recently dipped below 20. In 2014 to 2105, PEs above 20 warned that stocks were overpriced.

We can see from the green and orange bars on the chart that the primary reason for the dip in forward PE is more optimistic earnings forecasts for 2017.

S&P500 Earnings Per Share and Forward PE Ratio

We can also see, from an examination of the past history, that each time forward PE dipped below 20 it was an opportune time to buy.

History also shows that each time the forward PE crossed to above 20 it was an opportune time to stop buying. Not necessarily a sell signal but a warning to investors to tighten their stops.

Sector Performance

Quarterly sales figures are only available to June 2016 but there are two stand-out sectors that achieved quarterly year-on-year sales growth in excess of 10 percent: Consumer Discretionary and Health Care.

S&P500 Quarterly Sales Growth

Interestingly, apart from Energy where there has been a sharp drop in earnings, sectors with the highest forward PE (based on estimated operating earnings) are the defensive sectors: Consumer Staples and Utilities. While Consumer Discretionary and Health Care are more middle-of-the-pack at 16.7 and 15.4 respectively.

S&P500 Forward PE Ratio by Sector

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Beware of the CAPE

I have just read John Mauldin’s warning that the market is overvalued:

Not only does today’s CAPE of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years coupled with sluggish earnings growth suggests that this market is also seriously overbought, as I pointed out last week and as we are seeing play out this week.

CAPE

Robert Shiller’s CAPE ratio compares the current index price to a 10-year simple moving average of inflation-adjusted earnings in order to smooth out earnings and provide a long-term indication as to whether the market is under- or over-valued. But ratios are far from infallible. One of the first things fundamental investors/traders learn is: do not buy a stock simply because the Price-to-Earnings (PE) ratio is low, and never short a stock simply because the PE ratio is high. The reason is fairly obvious. In the first case, current earnings may be expected to fall and, with high PE ratios, earnings are likely to grow.

Let’s examine CAPE more closely. First, we have experienced the worst recession in almost a century; so does a moving average of the last 10 years adequately reflect sustainable long-term earnings? In the chart below I removed the highest and lowest quarter’s earnings in the last 10 years [dark green]. Note the visible difference losses reported in Q/E December 2008 make to the long-term average.

Price Earnings Ratio

The chart also highlights the fact that Shiller’s CAPE is relatively low compared to the last 15 years, where the average is close to 30. The normal PE of 18.4, calculated on the last 12-month’s earnings*, is also low compared to an average of 28 for the last 15 years.

*Reporting for the December quarter is not yet completed and unreported earnings are based on S&P estimates.

As novice investors learn, it is dangerous to base buy or sell signals on a PE ratio, whether it is CAPE or regular PE based on 12-months earnings. Using CAPE, we would have sold stocks in 1996 and again in 2003, missing two of the biggest bull markets in history. And we would have most likely bought in 2008, when CAPE made a new 10-year low, right before the collapse of Lehmann Brothers.

I submit that CAPE or PE ratios are not an end in themselves, but merely a useful tool for highlighting expectations of future earnings. At present both ratios are rising, suggesting that earnings prospects are improving.

Posted on

Beware of the CAPE

I have just read John Mauldin’s warning that the market is overvalued:

Not only does today’s CAPE of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years coupled with sluggish earnings growth suggests that this market is also seriously overbought, as I pointed out last week and as we are seeing play out this week.

CAPE

Robert Shiller’s CAPE ratio compares the current index price to a 10-year simple moving average of inflation-adjusted earnings in order to smooth out earnings and provide a long-term indication as to whether the market is under- or over-valued. But ratios are far from infallible. One of the first things fundamental investors/traders learn is: do not buy a stock simply because the Price-to-Earnings (PE) ratio is low, and never short a stock simply because the PE ratio is high. The reason is fairly obvious. In the first case, current earnings may be expected to fall and, with high PE ratios, earnings are likely to grow.

Let’s examine CAPE more closely. First, we have experienced the worst recession in almost a century; so does a moving average of the last 10 years adequately reflect sustainable long-term earnings? In the chart below I removed the highest and lowest quarter’s earnings in the last 10 years [dark green]. Note the visible difference losses reported in Q/E December 2008 make to the long-term average.

Price Earnings Ratio

The chart also highlights the fact that Shiller’s CAPE is relatively low compared to the last 15 years, where the average is close to 30. The normal PE of 18.4, calculated on the last 12-month’s earnings*, is also low compared to an average of 28 for the last 15 years.

*Reporting for the December quarter is not yet completed and unreported earnings are based on S&P estimates.

As novice investors learn, it is dangerous to base buy or sell signals on a PE ratio, whether it is CAPE or regular PE based on 12-months earnings. Using CAPE, we would have sold stocks in 1996 and again in 2003, missing two of the biggest bull markets in history. And we would have most likely bought in 2008, when CAPE made a new 10-year low, right before the collapse of Lehmann Brothers.

I submit that CAPE or PE ratios are not an end in themselves, but merely a useful tool for highlighting expectations of future earnings. At present both ratios are rising, suggesting that earnings prospects are improving.

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On Investment Time Horizons – Seeking Alpha

David Merkel observes that Shiller’s CAPE10 ratio and Tobin’s Q-ratio both “indicate that stocks are not likely to return a lot over the next 10 years”.

The CAPE10 ratio is a long-term, smoothed PE-ratio first popularized by Yale Professor Robert Shiller in his book Irrational Exuberance. CAPE10 compares the current S&P 500 index value to the average of the last 10-years annual earnings. James Tobin’s Q-ratio compares current price to net worth (total company assets minus liabilities).

Merkel points out, however, that “the same is true of most high-quality bond investments …. and high-yield investments when expected losses are netted out…..I am not crazy about buying bonds here. The risk-reward is awkward, but the same is true of stocks.”

Bottom line is investors are being starved of yield by the Fed’s Twist and QE3 operations. Investors may be forced to take on additional risk in order to boost yields, but that could end in disaster, with capital losses if yields rise or earnings fall. Where possible, the safest strategy would be to tighten your belt and sit this out.

via On Investment Time Horizons – Seeking Alpha.

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S&P 500 dividend yields signal oversold?

Historically the S&P 500 was considered overbought — and ripe for a bear market — when the dividend yield dropped below 3 percent. A surge in share buybacks in the past two decades, however, disrupted this relationship, with the dividend yield falling close to 1.0 percent in the Dotcom era.

S&P 500 Earnings and Dividend Yields

What happens when we adjust for share buybacks?

In 2011, S&P 500 share buybacks increased to $409.0 billion. With dividends of $298 billion*, that gives a total cash distribution (dividends and buybacks) of $707 billion for a yield of 5.44 percent. Right in the middle of the 5.0 to 6.0 percent range previously considered typical of an oversold market.

* S&P 500 market capitalization of $12,993 billion at June 29, 2012 multiplied by 2.29 percent

Unfortunately share buybacks fluctuate wildly with the state of the market:

S&P 500 Share Buybacks

If we omit the highest and lowest readings, and take the average share buyback over the remaining 3 years, it amounts to $349 billion. That would give adjusted total cash distributions of $614 billion and an adjusted yield of 4.98 percent — still close to the oversold range.

Compare to Earnings Yield

The current reported earnings yield of 6.8 percent, however, is way below the highs (10 to 14 percent) of the 1970s and 80s. Current distributions (dividends plus buybacks) amount to 80 percent of current earnings. Payout ratios above 60 percent are considered unsustainable.

My conclusion is that earnings yield offers a more accurate measure of value. And reflects a market that is fairly valued — rather than overbought or oversold — especially when we consider the likelihood of earnings disappointments.

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