Equities - what happens when the ‘P’ goes up while the ‘E’ goes down?

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All time record for S&P500.

As I write, the S&P500 just reached an all time record - hitting 3,000.

Importantly, this is not a result of a widespread expectation for bumper earnings growth. Rather, it’s a direct response to US Fed Chair Jerome Powell’s preparedness to consider rate cuts as a result of ongoing economic uncertainty - even in light of the recent surprise June jobs report which printed 224,000 new starts.

Implications for company valuations.

A company’s price to earnings ratio, or PE, is not the most detailed or accurate valuation yardstick, but it does provide a simple valuation ratio that can be compared across companies, industries and geographical markets.

Its two components are P (share price) and E (after tax eps). The P is the numerator and the E the denominator.

Share prices typically go up when a company is doing well, e.g., increasing earnings, and down when the opposite happens. Moves can also be, and are more often based on expectation and sentiment.

However, sometimes the P goes up because interest rates go, or are expected to go down (making equities a relatively more attractive investment) and not because of movements in earnings or other company specific factors.

This is where the P unhitches from the E, as it noticeably started to do when QE commenced over 10 years ago.

Currently, US interest rate expectations are back to being ‘lower for longer’, forcing up the P. Also, company earnings are at a risk of moving sideways or down as a result of the trade war overshadowing a seemingly strong jobs market, creating expectations for a lower E. So, PEs may be in for a bigger expansion.

What’s been happening to the US market PE?

On first blush, the US market PE (using the S&P500 PE as a proxy, derived from the trailing 12 months of earnings) is 22.29.

This is about 50% higher than the median PE of of 14.75 and indicates a general rise in PE levels, but not a massive differential.

Source: Chart by multipl.

Source: Chart by multipl.

To be fair, looking at only 12 months can distort the picture, so in attempt to remove/smooth out annual fluctuations, we look to the Shiller PE.

This is a ‘real’ measure and is based on an inflation adjusted (today’s dollars) 10 year eps average. The chart below shows the Shiller PE, as calculated by multipl.

At the moment, multipl shows the Shiller PE to be 30.5, which is almost double its median print of 15.7.

This is equivalent to double the rate of expansion indicated by the single year PE.

Source: Chart by multipl, partially using data sets published by Robert Shiller.

Source: Chart by multipl, partially using data sets published by Robert Shiller.

Yes, it’s true that some of the very low earnings results back in 2009 and 2010 (immediately following the GFC) will shortly fall out of the 10 year calculation and the Shiller PE might retreat.

On the other hand, if upcoming earnings go sideways or decline as a result of a continuing trade war, Brexit or other external factors, the low back-end earnings could be partially offset by flat/low earnings to come.

Of course it could also go another way and upcoming earnings might surprise on the upside, meaning share prices could continue upwards with little change to PEs.

Focus on whether the P is unhitched from the E.

But, there is an even greater probability of multiple expansion coming from the numerator.

That is, it’s easy to imagine the P going up as a result of more dovish moves or expectations from the US Fed and/or more accommodation and bail outs in China and Europe, regardless of movements in the denominator.

Opportunities and threats can both occur when the P and the E unhitch.

As always, it could go any number of ways and its never good to look at just one variable, but the point I’d like to make is that it almost always pays to keep an eye out for unhitched PEs, because as Wile E. Coyote continued to find out the hard way, gravity’s a b*&^!.

Mike.


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