Among market watchers, it's common to lament that everything seems overvalued. Whether it's price-earnings ratios or index funds garnering two billion dollars a day or the market reaching record levels, folks are worried that if they buy now, we could be replaying 1999 or 2007 - the boom before the bust. No one wants to go through those gut-wrenching declines again.
But what if the market deserves its high valuation? What if it lives up to the inflated expectations analysts have placed on it? The second part of the PE ratio is E - for earnings - after all. If earnings do better than good, then the market isn't as rich. How have earnings been so far this year?
The answer is striking. With almost all the companies in the S&P 500 having reported their results for the first quarter, earnings are on track to grow nearly 14% from a year ago. That's more than twice their long-term average growth rate of 6%, and about 50% higher than they were expected to earn. In fact, over half the companies beat analysts' projections by more than one standard deviation. That eliminates the chronic outperformers who "guide" expectations only to beat them by a penny or two. That's just a game that managements play. By contrast, this quarter's earnings season has seen massive outperformance.
S&P 500 Q1 Earnings. Source: Bloomberg
The strength was widespread: Industrial companies, banks, tech firms, and even some retailers did better than expected. And these weren't financially engineered results. Companies have spent 18% less buying back their own shares so far this year compared with last year. The economy appears to be strengthening around the world - not just in the US - and corporations are seeing this in sales and it's lifting their earnings.
So throw out that wet blanket and enjoy the summer sun. Stocks lead profits which lead the economy. Maybe we'll get out of our New Normal doldrums after all.