S&P: Let's Talk About Earnings And Valuation

| About: SPDR S&P (SPY)

Summary

GAAP earnings for 2015 were 30.7% lower than non-GAAP earnings.

S&P is currently trading at a forward P/E=16.5 while its 5-year and 10-year averages are 14.4 and 14.2, respectively.

Nevertheless, this article explains why these facts should not lead investors to conclude that the market is significantly overvalued.

While the stock market just celebrated the 7th year of the ongoing bull market, there is an increasing number of SA authors who characterize the market as overvalued and call for an imminent bear market. As all the companies of S&P (NYSEARCA:SPY) have reported their full-year results for 2015, I would like to address some indicators that are usually used to substantiate the overvalued status and explain why I believe that the market is not significantly overvalued.

First of all, many bearish investors claim that the average GAAP (generally accepted accounting principles) corporate earnings plunged in 2015 but the companies achieved decent results thanks to the use of non-GAAP earnings, which were markedly above the GAAP figures. Thus those investors claim that the real results of the companies are much worse than the adjusted results, which are used for the comparison over the year before and also for valuation purpose. First of all, there is a great dispute on which of the two figures is the most important. Some analysts claim that the non-GAAP earnings are more important, as they exclude non-recurring profits or losses and hence they are more appropriate for monitoring the performance of a company. On the other hand, some analysts claim that some companies exclude too high losses from their non-GAAP results and they thus present a much brighter picture than the actual one.

While there is no verdict on the above dispute yet, the reality is that the non-GAAP earnings of the stocks of Dow Jones (NYSEARCA:DIA) in 2015 were pronouncedly lower than the GAAP earnings. More specifically, the former were 30.7% lower than the latter in 2015 while they were only 11.8% lower in 2014. On the one hand, the widening gap of the two figures is a concerning factor. On the other hand, this gap does not indicate that an imminent bear market is just around the corner. For instance, most oil companies incurred excessive asset write-offs in 2015 due to the collapse of the oil price. These non-recurring losses have been correctly excluded from the non-GAAP results. Moreover, many companies, such as Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG) and General Mills (NYSE:GIS) are implementing restructuring projects in order to cut costs and increase their efficiency. Therefore, while their reported earnings are negatively affected by their high restructuring costs, the companies are likely to become more competitive and reap the benefits of their restructuring in their future. All in all, investors should keep monitoring the gap between the reported and adjusted earnings but there seems to be no evidence so far that too many companies mask their real performance via their adjusted results.

Another point of concern that is often mentioned by bearish investors is that S&P is currently trading at a forward P/E=16.5 while its 5-year and 10-year averages are 14.4 and 14.2, respectively. While this concern is not unreasonable, the record-low interest rates partly justify the current valuation of the market. Moreover, it should be noted that the forward P/E of the energy sector is extremely high (60.5) due to the collapse of the earnings of the oil companies that has resulted from the plunge of oil. If this extremely high P/E is excluded, then the forward P/E of the other S&P companies becomes significantly lower, approaching its 5-year and 10-year averages.

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Of course if the price of oil experiences a strong rebound, the earnings of oil companies will significantly increase but the earnings of other sectors will somewhat decrease. For instance, stocks that rely on consumer discretionary income are likely to be negatively affected if the price of oil records a strong rebound. Therefore, the extremely high P/E of the energy sector should not be fully ignored. Nevertheless, the energy sector distorts, at least in part, the overall valuation of S&P. Consequently, S&P is not as overvalued as some investors think due to its nominal P/E.

Another remarkable point is that the analysts have pronouncedly lower their estimates for Q1-2016 since the beginning of the year. To be sure, while the earnings per share [EPS] of Q1 were expected to grow 0.3% on December 31st, there have been numerous downward revisions, which have resulted to an expected EPS decrease 8.3%. This trend has been repeatedly observed in the last few years. It essentially sets the bar lower for the companies and consequently most companies exceed the analysts' estimates in every quarter. While this somewhat distorts the overall picture of corporate performance, it is not a strong evidence that a bear market is around the corner. As a side note, while the EPS of S&P for the full year 2016 were expected to grow 6.8% on December 31st, they are now expected to grow only 2.7%.

Finally, it is worth noting that, if the S&P earnings decline in Q1, it will be the first time since Q3-2009 that the earnings decline for 4 consecutive quarters. In addition, if the current consensus is proven correct, it will be the largest EPS decline since Q3-2009 (-15.7%). Therefore, there is a good reason that S&P has remained essentially flat in the last one and a half year. Nevertheless, it is only natural that the corporate profits and S&P may consolidate for a few years before making their next move up.

To sum up, it is not unreasonable that many investors are afraid of an imminent bear market after 7 years of a rising market. This is also justified by the slightly decreasing earnings of last year and the expectations for essentially flat earnings this year. Nevertheless, the above evidence does not mean that there is an imminent bear market ahead. A consolidation phase before the next leg up is a healthy development, as the market cannot keep rising on a straight line. Therefore, investors should ignore the short-term noise, which may include a correction or a cyclical bear market, and focus on the big picture, which is the ongoing secular bull market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.