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Market Commentary: What could make earnings grow from here?

As investors, making money is the goal.

Written by: Benjamin Bimson CIMA® / BCJ Financial Group

Keeping the money that we make in our investments should also be a goal, and I have not heard a single argument that the stock market is not at a high value, no matter how the numbers are calculated.

According to Ned Davis Research’s (NDR) most recent valuation of the S&P 500’s Median Price/Earnings Ratio (P/E), the market is solidly in the “overvalued” category. The May 31, 2017 P/E is 23.6. The 53.3-year median P/E is 17.0. Hmmm.1

Referring back to our discussion last week of “narrow leadership,” would it be cheaper to examine each sector than take the average of the averages? The short answer is surprisingly, no.

NDR discovered that taking each P/E for each of the economic sectors represented in the S&P 500, the new “sector-neutral” median P/E (as NDR refers to it) is still overvalued. The sector-neutral version of the P/E is at 24.4 versus its 45.3-year average of 16.7.

Here are two charts that show the two different ways looking at the median P/E ratios. The first one is the standard all-S&P 500 stock in the weightings it is found in the index. The second one separates the stock sectors found in the S&P 500 and takes the P/E for each sector and then calculates a median P/E from the sector P/E ratios.

 

 

Chart Source: Ned Davis Research

Chart Source: Ned Davis Research

 

Chart Source: Ned Davis Research (1)

Chart Source: Ned Davis Research (1)

 

On the surface, this data seems very concerning and it is certainly not something to ignore. However, making money in investments is not as simple as seeing where the current P/E ratios are in relationship to the longer-term medians.

Since the ratio being considered is the price of the stock relative to the underlying earnings of the companies themselves, P/E ratios can come down without markets crashing if earnings rise in the underlying corporations.

What can make earnings grow from here? Economic growth. We need to get economic expansion to support the P/E ratios we see in stocks. So far, the expansion has been there, but the stock market is anticipating more than the latest data shows. It is anticipating if economic activity will grow from here. The following chart shows the last 10 years of Leading indicators. Notice that in a recession, where most stock market losses occur, the growth is negative.

 

Chart Source: myf.red/g/dXbo

Chart Source: myf.red/g/dXbo

 

Where are we going to get that growth? It can come from a variety of sources and not just from potential tax reform or changes to tax codes here in the United States. Global economic activity has been improving over the last year and that can help as well. The stock market seems to be indicating that it believes that global economic growth is healthy enough to support these overvalued stock prices for now. There are certainly risks, but there has never been a time free from risk.

What could indicate we are at the top? There are several indications, and most have some relationship to interest rates. The yield curve has typically become inverted before a major recession. The chart below shows the yield curve back in March of 2007. Look in the bottom right corner to clearly see that the shorter bonds had higher interest rates than longer term bonds. This provides no incentive for investors to purchase longer term bonds since they would be paid less than if they purchased short term treasury bills.

 

Chart Source: BCJ Financial Group

Chart Source: BCJ Financial Group

 

Now, notice where current interest rates are (which is normal of a healthier economy). When the economy is expanding, there is more interest paid for longer term bonds than short term bonds.

 

Chart Source: BCJ Financial Group

Chart Source: BCJ Financial Group

 

Recently the yield curve has been “flattening,” but until it actually inverts, it would not be a signal. The last chart I will show you is to give context. This is the long term curve and when the front of the 3D graph is low versus the long term, you will see a lot of green. When it is going inverted, you will see mostly or all red. This chart is from 7/1/2001-4/1/2017.

 

Chart Source: BCJ Financial Group

Chart Source: BCJ Financial Group

 

There are many more indicators that we monitor daily and take an approach that looks at all the evidence rather than simply choosing one indicator. We do this because so much of the market news can tend to over-simplify, and attach huge predictions based on limited data. This can be a very dangerous thing to do.

The goal is to make money when we can and protect gains when it makes sense. There are times that even this approach can be misleading because plain and simple, no one has a crystal ball. However, the approach we use tends to have fewer incidents of prolonged caution when the economy is doing well and improving, as well as fewer incidents of prolonged optimism when the warning signs are growing in number.

Data is king when it comes to making money in investments. We do our best to navigate the waters and take information seriously. There are many mixed signals at this point but increasingly it looks like grave danger might still be some ways off. If that changes, we will be sure to be quick to change our approach and let you know why.

 

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1-U.S.Markets. Ned Davis Research Group. May 31, 2017. [6/5/2017]

Securities offered through World Equity Group, Inc. Member FINRA/SIPC. Advisory Service offered through BCJ Capital Management. World Equity Group, Inc. and BCJ Capital Management are independently owned and operated. Investment advisory services are offered through BCJ Capital Management, an SEC registered investment adviser. BCJ Capital Management is a (SEC) registered investment adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. BCJ FG 17-479

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