October 7, 2023

A Look-See into E and P/E

Santa Claus looking closely at something through the falling snow

Bottom Line:


Accurate market forecasting only requires correctly forecasting earnings and valuations. After a year-long draught, earnings this quarter will print positive and earnings should continue to grow over the next several quarters. This contributes fundamental uplift that investors have lacked for a year. The rapid rise in interest rates has depressed valuations, but accumulating confidence in disinflationary trends should offer relief. Should rates stabilize, valuations will as well. With earnings rising and valuations stabilizing, the market only lacks rising investor sentiment to ignite a year-end rally. We have called for a bottom in bullish sentiment below 25% as the buy signal (down from 51% in July). We reached nearly 28% last week. This is an imprecise business, but we do have a key inflation report to get through next week. Should inflation tick higher, sentiment will tick lower still. Should that report prove benign, it’s time to cue the Claus!



The Full Story:


If you want to know the future value of a chosen market index, you need only to properly forecast two variables. First, you must properly forecast future earnings (E). Second, you must properly forecast future valuations (P/E). For instance, if you expect $100 in future earnings and a 20x valuation, you will forecast your index value at 2,000.


Each day, the news clips that snow-blind analysts make their way into adjustments in earnings expectations and valuations expectations. Let’s first level set with each of these variables and then make determinations on direction to inform our own year-end forecast.


E is for Earnings


Q3 earnings season kicks off next week, ominously, on Friday the 13th. For the past three quarters, earnings have declined compared with year ago levels, a rare occurrence outside of recession as seen below:


A chart showing S&P 500 Operating Earnings Per Share


For the upcoming quarter, analysts expect another, albeit slight, earnings decline. Based upon upside surprises over the past few quarters, we expect the final tally for this quarter will result in positive earnings growth. If that’s the case, this will be the first positive report in a year!


For the fourth quarter, analysts currently forecast an 8% earnings growth rate. For 2024, analysts forecast a 12% growth rate. Many doubt these figures for a myriad of reasons, but if you squint at the visual above, earnings transitions from negative to positive tend to unlock outsized upside.


The Dow rallied 300 points on Friday. The September labor report detailed 366,000 payrolls added last month versus the 170,000 anticipated. Continued labor market strength translates into continued consumer spending strength which translates into continued economic strength and therefore, earnings strength. This report only increased the odds of a positive third quarter earnings season.


P/E is for Valuations


Currently, the S&P 500 trades for approximately 18x estimated earnings. If we compare this level with long-run averages, the current valuation appears stretched:


A chart showing S&P 500 PE 1960 to present


Clearly, however, valuations vacillate. The runup in valuations from 1980 to 2000 (8 to 25) provided an enormous tailwind for S&P 500 investors. Likewise, the fall in valuations from 2000 to 2010 (25 to 12) provided an enormous headwind for investors. Investors gained 18% annually through the 1980’s and 18% annually through the 1990’s. In the 2000’s investor returns dropped to -1% annually.


Clearly, valuation trends matter (it’s math). Currently, the S&P 500 valuation trend better resembles the sideways chop of the 1960’s. Over the decade of the 1960’s, the S&P provided investors with returns of 8%, reliant on earnings growth and dividend yields for lift, as seen below:


A table showing 1930 to 2013 S&P 500 Data


Larger directional trends in valuation stem from larger directional trends in interest rates. As bond yields fall, equity valuations rise to maintain equilibrium between the two asset classes, and vice versa. Note that in the chart above, the trend upward in rates through the 60’s and 70’s corresponded with lower total returns for stock investors, while the trend downward in rates through the 80’s and 90’s corresponded with higher returns.


Interest rate calculations include forecasts for inflation, creditworthiness, Central Bank policy and marketplace liquidity. In other words, it’s complicated. However, in our current environment, any reports of disinflation or Federal Reserve policy downshifts places downforce on interest rates and therefore upforce on valuations.


The September labor report showed a continued glidepath lower for wages, with average hourly earnings rising 4.1% over the past year—only 3.4% when using a 3-month rolling average. The Fed wants wage growth of around 3%, bringing the target within range.


Continued wage disinflation supports continued disinflation overall, reducing pressure on the Fed to do more, and reducing pressure on long-term interest rates. As such, this report added upward pressure on P/E and improved the odds that valuations need not fall further into year-end.


Paging Mr. Claus


Taken together, with earnings gaining positive momentum starting October 13th and interest rates potentially stalling out at these levels (dependent upon the upcoming CPI inflation report on October 12), markets now appear anxious to rally into year-end.


The one pre-condition we set for the start was a sentiment decline down to 25% bulls. We didn’t get there. We got down to 27.8% at the end of last week. However, when the market fell 270 points early Friday morning, I heard a bearish strategist on CNBC declare, “Everyone is afraid of everything right now!” and felt that our sentiment correction call seemed well-enough fulfilled. We must clear the CPI report first, but should that arrive benign, it’s time to cue the Claus.


Have a great weekend!


David S. Waddell

CEO, Chief Investment Strategist




Source: Yardeni


David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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