Amid Earnings Deluge, Stocks Fail To Reach Escape Velocity
Despite marginal new highs in the S&P 500 Index, stocks remain caught in a trading range, with a better-than-normal proportion of upside profit surprises for the March quarter countered by a worse-than-normal proportion of revenue shortfalls.
Consensus profit expectations for full-year 2015 continue to erode, reflecting mostly downbeat guidance. But profit growth is expected to resume in the second half of the year, and bulls argue that even modest earnings momentum should be enough to sustain the bull market in stocks given the lack of appealing alternatives. Relative to long-term norms, the spread between bond yields and earnings yields (earnings/price ratios) on stocks suggests that stocks are undervalued. For more on this topic, read the cover story in next week's issue of the Forecasts.
Bears argue that valuations are stretched, that stocks should not be trading at unusually rich valuations when profit growth is unusually low. The S&P 500 Index trades at 17 times expected year-ahead earnings, a more than 21% premium to the 10-year norm, according to FactSet. Yet consensus estimates for the index, which are almost certainly optimistic, project just 2% growth in per-share profits for 2015.
So, who is right?
The bulls are right that stocks are cheap relative to current bond yields. If you expect inflation and bond yields to remain near present levels for the next 10 to 20 years, stocks are arguably a bargain even if earnings grow at only half the typical rate. But if — like us — you think yields on 10-year Treasury bonds could jump to 4% from the current 2% quickly if inflation accelerates and the global economy gains traction, the case for stocks being cheap is no slam-dunk.
In fact, the bears are right that stocks are expensive, though the situation is not as dire as the capitalization-weighted S&P 500 Index suggests. First, the energy sector trades at 31 times expected year-ahead earnings; no other sector trades at more 20 times. Second, March-quarter earnings for the index are expected to be up 5.6% excluding the energy sector — compared to the 2.8% decline expected for the full index. Excluding energy, year-to-year growth of more than 5% is expected for all four quarters of 2015.
The median company in the S&P 500 is expected to deliver current-year earnings growth of more than 6%, meaning one-half of S&P 500 companies are expected to deliver at least 6% growth. As shown in the nearby table, the median stock in the S&P 500 has a trailing P/E of 20 — an 18% premium to the 10-year norm and a 10% premium to the 20-year norm.
Moreover, while the number of truly cheap stocks is quite low, the number with middling P/Es is roughly in line with 20-year norms. As shown in the table below, 17% of S&P 500 stocks have trailing P/Es of 12 to 16, versus the 20-year norm of 21%.
Valuations and growth rates are not as bad as implied by the S&P 500 Index, and we are still finding growers trading at reasonable valuations. For now, we intend to watch the averages and look for opportunities one stock at a time while holding about 85% of our buy lists in stocks. For new buying, especially promising year-ahead picks include Lear ($112; LEA), Jones Lang LaSalle ($168; JLL), and United Rentals ($98; URI).