Looking at The Big Picture: Earnings and Valuations

December 9, 2019|4:59pm


Don’t look now fans, but the number of trading days left in calendar year 2019 are dwindling fast and the holiday season is right around the corner. How the heck did that happen?

It’s the time of year when we are supposed to be stepping back from the blinking screens and focusing on the season. But with tariff deadlines looming, stocks lurching to and fro in reaction to every trade tweet, and an impeachment process in full swing in D.C., this doesn’t seem like the best time to be taking one’s eyes off the ball.

This is also the time of year where analysts of all shapes and sizes like to look into their crystal ball and opine on what to expect in the coming year. So, while we’re waiting for the next hearing to begin, I thought it might be a good idea to look at some of the factors that could come into play in 2020.

To be clear, this is not going to be an exhaustive list of everything that could happen next year. No, the plan this morning is to take a look at a couple of the fundamental underpinnings of the stock market. Stuff like earnings and valuations.

Let’s Start With Earnings

First up, let’s look at the earnings picture. It is said that earnings are the lifeblood of the stock market. While I can/will argue that this is not always the case as the drivers of market environments tend to vary from cycle to cycle, I do believe that a great many investors/analysts/portfolio managers are focusing a fair amount of their analysis energies on the upcoming year’s earnings picture. So let’s take a look.

First up, let’s look at the Consensus Estimates for the Operating Earnings of the S&P 500. The chart below shows the Street’s consensus estimates for calendar year earnings, plotted over time.

View Chart Online
Source: Ned Davis Research Group

There are several items worthy of note here. First, this chart clearly shows that consensus expectations over the past 8 years have tended to start off way too high. Over time, as reality sets in, the expectations tend to move steadily from the upper left to the lower right. And with the exception of 2018, which saw analysts react to the benefits of the tax cut, the final EPS for the index finished each year well below where the estimates began.

Next, note that with the exception of 2015 (a year that saw an earnings recession caused by the meltdown in the oil patch), year-over-year earnings have risen. And from an uber-simplistic point of view, this can be used to “esplain” why stocks tend to rise during most calendar years.

If you are looking for an explanation of the 2018 debacle that flew in the face of S&P 500 EPS growing from $124.51 to $151.60 in 2018, the answer lies in the shape of 2019’s estimate plot. Note that analysts started off expecting earnings to improve smartly in 2019 as estimates were rising. But then the dynamic duo of the trade war with China and the Fed becoming overly tight created a fairly dramatic shift in expectations. And as the uncertainty caused by our friends in Washington grew, the selling began.

The bottom line here is to remember that the stock market is a discounting mechanism for future expectations and thus, stocks tend to look ahead and not back.

The next item of note is that EPS is currently expected to increase by 11.4% in 2020, with the current estimates standing at $176.74. From this number, we can apply a multiple in order to come up with a guesstimate for where the S&P might finish the year. The questions, of course, include: (a) what is the appropriate multiple for the environment and (b) will the decline in estimates continue/get worse?

On the question of whether or not the decline in estimates can be expected to keep moving down and to the right, I’d like to direct your attention to another version of earnings estimates. Instead of using Operating Earnings, which tend to involve a fair amount of “financial engineering,” the chart below looks at EPS estimates from a GAAP (generally accepted accounting principles) perspective.

View Chart Online
Source: Ned Davis Research Group

The first thing to note on this chart is that GAAP EPS is currently expected to increase by nearly 15% next year. And from my perch, this could be a decent argument for the current leg of the bull having some room to run.

In addition – and you may need to click on the link to view a larger version of the chart to see this point – I find it interesting that the most recent move in the GAAP estimate plot is up. Although this could certainly prove to be nothing more than a temporary interruption to the downward trend, one could argue that the current pace of downgrades could be slowing. Or not. We shall see.

A Quick Look At Valuations

For those who like to keep score at home, one of the best ways to determine the appropriate multiple to apply to earnings expectations is to look at history.

Below is a chart of the GAAP P/E Ratio going back to 1926. The GAAP P/E currently stands at 23.63, which by historical standards, well, let’s just say it isn’t cheap. And it is for this reason that our furry friends in the bear camp contend that the valuation of the stock market is stretched.

View Chart Online
Source: Ned Davis Research Group

But (again, you had to know that was coming!)… I have long contended that there are really two distinctly different eras on this chart, which I’ve illustrated below.

View Chart Online
Source: Ned Davis Research Group

In short, the GAAP P/E of the S&P remained in a tidy range between 6 and 28 for more than 65 years. However, my thinking is that the advent of the 401K as the public’s primary retirement savings vehicle and the corresponding constant demand for stocks, changed the game.

For this reason, I’ve drawn a box around the GAAP P/E from the mid-1990’s forward.

Cutting to the chase, the current reading of 23.63 is by no means extreme when viewed in this timeframe. A timeframe that now spans 25+ years, which is getting to be a long time.

Yes, I will agree the spike in 2008-09 was a one-off and should be discounted. And I will also agree that the spike caused by the tech bubble bursting should also be taken with a grain of salt.

My point here is that the average GAAP P/E over the last 25 years is 25.63. And if one eliminates the two outliers, I can argue that a high valuation reading might be somewhere in the 28-30 zone. Or another way to look at the situation is to note that the most recent peak seen in early 2018 was somewhere above 26.

Thus, I will suggest that stocks are not extremely overvalued here when viewed from a GAAP P/E point of view over the past 25 years. And because of this, if investors were to get a positive resolution on the trade front and an uptick in economic activity, I will also argue that additional multiple expansion is possible.

Finally, let me emphasize that stocks don’t move in a straight line and that a 10% correction can happen at any time, for just about any reason. But for me, the key is to recognize that there is a path forward to higher stock prices – if we stop shooting ourselves in the foot, of course.

Weekly Market Model Review

Each week we do a disciplined, deep dive into our key market indicators and models. The overall goal of this exercise is to (a) remove emotion from the investment process, (b) stay “in tune” with the primary market cycles, and (c) remain cognizant of the risk/reward environment.

The Major Market Models

We start with six of our favorite long-term market models. These models are designed to help determine the “state” of the overall market. Put another way, these models indicate which team is in control of the primary trend.

The are no changes to report on the Primary Cycle board this week. However, there has been a lot of talk lately about this move looking/feeling like a “blow off” top to the current cycle. While anything is possible in this game (personally, I worried more about a blow off top in January 2018), my six favorite big-picture models suggest that the indicators are largely in sync us that the bulls be given the benefit of any doubt at this stage of the game.

The State of the Fundamental Backdrop

Next, we review the market’s fundamental factors in the areas of interest rates, the economy, inflation, and valuations.

Ditto for the Fundamental Factors board as there were no obvious changes again this week. However, there was one modest move within a component indicator that is worthy of note. While the current signal is still “buy” and the rating remains positive, the reading of the Inflation Composite has been moving toward the neutral zone and is currently at the lowest reading since October 2018. To be sure, this is NOT a warning that inflation is becoming a problem. No, my take is more along the lines of the tailwind of low inflation is beginning to wane and that a more neutral environment for inflation expectations MAY be developing. Stay tuned, this could be an important development in the coming months.

The State of the Trend

Next, we review the state of the current trend. This board of indicators is designed to tell us about the overall health of the current market trends.

For at least the two weeks prior to last week’s report, I had warned that some sort of break in the upside action was likely in the near-term. For example, last week, I wrote that “a pullback, a correction, or at the very least, a pause in the uptrend is to be expected. As such, a test of the trend (and the bulls’ resolve) wouldn’t surprise anyone at this stage of the game.” Right on cue, the President waffled on the trade deal and stocks pulled back about 2.5% in short order (oh and Monday’s surprisingly weak manufacturing report didn’t help). However, with the narrative/expectations surrounding the next round of tariffs improving and a stunning jobs report, the pullback was largely erased by Friday’s close. However, with the chart of the S&P now littered with gaps and resistance overhead, my take is the current trend leans a little more neutral than the Trend board indicates – at least from a short-term perspective.

The State of Internal Momentum

Next, we analyze the “oomph” behind the current trend via our group of market momentum indicators/models.

There can be no arguing that the Momentum board remains in pretty good shape. But (you knew that was coming, right?), when digging into the component indicators, I will note that it wouldn’t take much downside action for this board to slip into the neutral zone – again, from a shorter-term perspective. Longer-term, things continue to look solid.

Early Warning Signals

Once we have identified the current environment, the state of the trend, and the degree of momentum behind the move, we review the potential for a counter-trend move to begin. This batch of indicators is designed to suggest when the table is set for the trend to “go the other way.”

With this market tied largely to the headlines on trade, we can’t put too much emphasis on the state of our Early Warning indicators. For example, the table had been set nicely for the bears, but some positive headlines turned the tide and the bears didn’t get much done with their opportunity. And looking at this week’s board, I will argue that the bears’ advantage has largely dissipated as the board is now largely neutral. My take is that stocks are likely to remain range-bound until we get clarity on the 12/15 tariff deadline.

Thought For The Day:

I don’t mind what Congress does, as long as they don’t do it in the streets and frighten the horses. – Victor Hugo

All the best,
David D. Moenning
Investment Strategist

David D. Moenning


At the time of publication, Mr. Moenning and/or Redwood Wealth Management, LLC held long positions in the following securities mentioned: None

Note that positions may change at any time.

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