Stock Prices Pull Ahead of Profits: Break From Cyclical Valuation Patterns?

Includes: DIA, QQQ, SPY
by: William Trent, CFA

We have written before about long-term valuation cycles in the stock market. In fact, a key reason for our overall cautious outlook is that we believe we are currently in the middle of a long-term valuation contraction in which price/earnings multiples will contract to well below their historic average. This does not mean we expect stock prices to fall - it means we expect them to grow at a slower rate than corporate profits.

Earlier this week Econoday published the following information:

Even with the stock market’s troubles during March, the S&P 500 index still posted a first-quarter year-on-year gain of 8.8 percent. This will prove about 3 percentage points higher than underlying profit growth, perhaps not that significant though the fourth-quarter also saw a 3 percentage point gap. These mark only the third and fourth times during the expansion that year-on-year share-price appreciation has exceeded profit appreciation. It’s also, as highlighted by the red arrows, the first back-to-back overshoot on the chart. Given the stock market’s current rally and the modest outlook for second-quarter profits, a third straight overshoot may be in the works.

stock appreciation

The trend during this expansion has been exactly in accordance with our thesis - in all but three of the past 20 quarters (and probably a bit more) stock prices have indeed underperformed corporate profit growth. At this point, we are approaching historically average valuations (though some would argue that we aren’t even that far along).

Will the stock market break away from the cyclical valuation patterns, and now simply match profit growth - forever trading at the average valuation? We doubt it. We think the average valuation will continue to represent an equal number of observations that are above average and below average. And that means we still think the odds are for below-average observations ahead.

Still, it is important to keep track of predictions and to recognize when reality is not living up to the forecast. So far, we are inclined to think the recent trend is noise. But a couple more quarters of stock gains exceeding corporate profit growth would justify taking a much harder look at our cycle thesis. In the meantime, though, we remain cautious.