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Fundamentally, stock prices are equal to the underlying earnings times whatever multiple investors place on those earnings (the price/earnings or P/E ratio). Algebraically, that’s P = Earnings x P/E. The price/earnings ratio varies over time based primarily on the level of interest rates and inflation but is also impacted by investor psychology in the short run. When inflation and interest are low, PE’s tend to be higher as shown in the graph below.
This makes intuitive sense because investors will not value as highly earnings that are a function of inflation. Moreover, periods of low inflation are associated with low interest rates. If the current value of a stock price is equal to the present value of its future cash flows discounted at current interest rates, then a lower discount rate will produce a higher stock price relative to those earnings (i.e. a higher P/E ratio). While the Fed just lowered the fed funds rates for the first time since 2007, it is longer-term interest rates that are the primary determinant of valuations. In that regard, the 10-year Treasury has been declining since November when it reached 3.25% (currently 1.96%). That decline in interest rates has pushed up the P/E multiple thus far in 2019 and that has accounted for virtually all the market’s advance this year.
The current rate of inflation is below 2%, so historically, that has led to an average P/E ratio for the S&P 500 of 16.6 times year ahead earnings. The current forward P/E ratio for the S&P 500 is 16.9 based on earnings estimates of $176.28. Thus, the overall stock market may be considered fairly valued at this point, and earnings growth will be the primary driver of further advances in stock prices moving forward.
At the start of the second quarter, consensus estimates indicated a decline of approximately 5% in S&P 500 earnings versus last year’s second quarter. With nearly ¾ of the 500 companies having now reported second quarter results, revenues are 4.4% higher than a year ago while earnings are 1.8% higher. The earnings growth would be higher yet if not for the 32% earnings decline in the materials sector due to the global oversupply of many materials.
Expectations for longer-term earnings growth are being tempered by trade wars and tariffs and the strong dollar. With the P/E multiple already at a level commensurate with current interest rates and inflation, future stock market returns are likely to be significantly lower than they have been over the past decade. However, given the historically low level of interest rates, stocks are still likely to outperform bonds and cash over the next several years.
We continue our focus on discovering individual companies with above average profitability and growth whose stocks are selling at attractive valuations.
Craig A. Vander Molen, CFA, CPWA ®
Managing Director and Chief Market Strategist