The stock market may be counting its chickens before they hatch. Prices appear to reflect optimistic forward earnings estimates as though they had already occurred. The correlation between operating earnings and price over the last 17 years suggests the forward annual earnings estimated for the fourth quarter of 2014 at 123.09 are priced into the market as a present reality and that the stock market is more overvalued than it was at the 2007 high.
The chart above is based on 12 month trailing operating earnings and the monthly average of the daily closing prices of the S&P 500. Each point in the scatter plot represents the price on the vertical axis and the latest available 12 month trailing operating earnings on the horizontal axis. The data point for May 2013 is based on the average daily price through May 28th at 1639 and 12 month trailing earnings, 98.32, calculated using three quarters of actual earnings and the 1st quarter estimate based on 99.1% of companies reporting. The best fit line in green shows the statistical correlation between earnings and prices since 1996.
The same data is shown in the time-series plot on the right. The calibration of the green vertical scale for earnings is based on the slope of the best fit line from the scatter plot. The average price for May of 1639 would be consistent with earnings of 121. So the price appears to be 23% too high or the earnings are 23% too low for the current price.
Using as reported earnings the stock market appears even more overvalued. The current average price for May would be consistent with 12 month trailing earnings at 116.93 which is 33.4% above the 87.69 estimate based on actual earnings for the last three quarters of 2012 and the estimate for first quarter of 2013 with 99.1% of companies reporting.
The relationship between price and earnings has been different since 1996. Prior to 1966, the slope of the correlation between prices and earnings was steeper, where an increase in earnings corresponded with a larger increase in price than it has since 1996. This change in relationship may have to do with market valuation. Several measures of valuation went to unusually high levels in 1996 which prompted Alan Greenspan's famous quote about "Irrational Exuberance." Some of these valuation measures include Robert Shiller's P/E 10 sometimes referred to as cape (cyclically adjusted price earnings), Tobin's Q ratio, the ratio of stock market valuation to GDP and the PEses that I use.
Since 1996 the PEses has averaged more than twice what it did prior to 1996. The 2009 low did not even get down to the historical average. While the current PEses of 41.5 is below the average of the last 17 years, it is higher than any time prior to February 1997. By this measure we are more overvalued than the highs in 1929 or in the 1960s. This article includes more information on the PEses.
The valuation indicated by the PEses is quite similar to the ratio of the stock market capitalization to GDP. The R-squared is 0.93.
While these two measures of valuation fit tightly through most of their history, since 2009 the capitalization to GDP ratio has risen quicker. This may be a function of domestic stock prices outside the S&P 500 rising much faster than the S&P 500. The broader stock market may be even more overvalued.
The last data point for the capitalization to GDP ratio is for the fourth quarter of 2012. If this ratio rose proportionally as much as the PEses has from December to May the ratio would rise to about 1.15 or almost as high as the peak valuation in 2007. This potential rise is represented by the light blue line at the end of the capitalization to GDP ratio in the chart above.
What If Earnings Fall
Actually, earnings have already fallen. Real as reported annual earnings are 2.4% below where they were a year ago. Annual operating earnings are below their high of three quarters ago, but have not had an annual decline, unless you take out inflation- in which case they are down small fraction from a year ago.
Weak GDP growth could mean much weaker earnings. The growth rate in earnings is probably still connected to the growth rate of GDP, but the band connecting them may work like rubber and has stretched out about 5 times more than it was prior to 1984. The chart below shows the annual real growth rates of GDP and earnings of the S&P 500.
Earnings have always fluctuated more than GDP growth, but the degree of fluctuation has expanded several fold in the last 30 years. The growth rate in real annual as reported earnings has been plummeting since 2010. It reached an astounding 776% coming out of the great recession, but has now dropped to -2.4%. This is close to where the 2.05% annual real GDP growth rate suggests it should be. In the last few years, a 1% change in the growth rate of GDP might correspond to a 15 to 30% change in the growth rate of earnings. Further modest declines in the rate of GDP growth could correspond with rapid declines in earnings.
It may also be telling to compare the 7 year GDP growth rate with the 7 year growth rate in real earnings.
Since 2000, the 7 year GDP growth rate (shown by the red line with the red scales) has declined steadily from 4.0% to 1.0%. The 7 year growth rate in earnings is shown by the black line with the black scales. It had a peak growth rate in 2000 of 12.7% and has bounced around sharply the low was -18.8% in 2009. From that low it bounced up to 7.9% in 2010. In the 7 years through 2013, Q1 real earnings growth has annualized 0.5%.
Depending on preconceptions, numerous interpretations could be projected into what this wild pattern of earnings mean. What makes the most sense to me is that earnings growth and economic growth are still connected. The trend in GDP growth reveals the underlying trend in earnings and the growth rate in earnings has been fluctuating around the declining growth trend with increasing volatility. If this is the pattern, it appears the next big plunge in earnings that takes the 7 year earnings growth rate into negative territory is about to begin. In the chart, this would continue the pattern of the black line alternating between soaring above the red line and plunging below it.
I am expecting another recession and drop in earnings at least as bad as the S&P 500 had with the 2001 recession. The next year should reveal whether this is an unwarranted bias or an accurate, but premature analysis. It is not yet clear if the stagnation in earnings growth over the last year is the beginning of a plunge in earnings.
If, as reported, earnings were to decline 54%, as they did with the 2001 recession, that would take them from the high a year ago to 40.73. The correlation of as reported earnings and price above suggests this would be consistent with the S&P 500 being at 1080, about 34% below current levels. Of course, it would be typical for the price to overshoot that level and fall more than 34% if earnings fell 54% in a recession.
The unhatched eggs the stock market assumes hold double-digit earnings growth the next two years may be rotting. Disappointment is almost inevitable. Before a bear market could begin in earnest, we would probably have to have a modest correction and the recovery from that correction fail to make a new high. When the psychological upward momentum is broken, stocks (SPY) could have a long way to fall.
Disclaimer: There is no guarantee analysis of historical data their trends and correlations enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.