Earnings Arrive Amid Worries

10/13/2014


U.S. stocks enter third-quarter earnings season on the back foot, with investors worried about the potential profit implications of slowing overseas economies, falling commodity prices, and the surging U.S. dollar.

The S&P 500 Index is within 2.5% of its September all-time high, as big U.S. blue chips have held up relatively well. But the S&P SmallCap 600 Index is down more than 10% from its July all-time high — and most of its 600 members have declined over the past 12 months.

MEDIAN P/E RATIOs AND GROWTH RATES
------- Median Trailing Price/Earnings Ratio -------
S&P
SmallCap 600
S&P
MidCap 400
S&P 500
(Large-Cap)
Largest 50
In S&P 500
Recent 
19.8
19.6
18.6
17.0
Norm since Oct. '94
18.0
18.0
18.0
20.1
Recent as % of norm
110
109
103
85
% of months lower than
recent since Oct. '94
72
81
62
31
Median Trailing 12-Month Change
------------------ In Per-Share Earnings ------------------
S&P
SmallCap 600
S&P
MidCap 400
S&P 500
(Large-Cap)
Largest 50
In S&P 500
Recent (%)
5.9
9.3
8.5
8.2
Norm since Oct. ‘94 (%)
9.0
9.5
9.8
12.0
Recent as % of norm
65
98
87
69
% of months lower than
recent since Oct. '94
20
37
26
16

Small-stock valuations have become more attractive but are not cheap — unless you adjust for today's unusually low bond yields. The median S&P 600 stock has a trailing price/earnings ratio of 19.8, down from 22.4 on Dec. 31 but above the 20-year norm of 18.0. On 72% of month-ends over the past 20 years, the median P/E has been lower than it is today.

While S&P 500 stocks have outperformed their smaller rivals over the past year, that partly reflected superior earnings growth. As a result, big-stock valuations have also improved. The median S&P 500 stock trades at 18.6 times trailing earnings, only 3% above the 20-year norm. Based on median P/E, the S&P 500 trades at a 6% discount to the S&P 600, versus a 12% discount on Dec. 31.

Implications

Without expectations of continued solid earnings growth, U.S. stocks are not particularly cheap, so the reaction to third-quarter results will be crucial. For the largest companies, which have the cheapest stocks but also the most overseas exposure, investors will be listening for outlooks on China and Europe, along with foreign-currency headwinds. For smaller companies, investors want to know if their still-premium valuations are justified by superior growth prospects.

With the Dow Theory bullish, we intend to watch the averages as we hold 91% to 94% of our buy lists in stocks.

 


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