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It's All About The Multiples

Russ Koesterich, CFA profile picture
Russ Koesterich, CFA

Despite unusually high expectations, companies are actually delivering on first quarter earnings. Roughly halfway through reporting season, 74% of companies reporting sales and 79% reporting earnings are beating expectations, both above the five-year average. Still, the market cannot get out of its own way. The S&P 500 Index remains nominally down year to date.

Why are investors ignoring strong earnings?

The simple answer is they're not. Instead, the answer lies with stretched valuations and changing economic and financial market conditions.

After peaking at nearly 23.5, an eight-year high, in late January, the trailing price-to-earnings ratio (P/E) of the S&P 500 fell roughly 14% to below 20 (see Chart 1). While valuations have recovered a bit in recent weeks, the trailing P/E on the S&P 500 remains below where it started the year. After more than seven years of relentless multiple expansion, investors seem to be reconsidering paying ever more for a dollar of earnings. While the most obvious culprit is higher interest rates, the reasons for lower multiples are more nuanced. They include:

1. Financial conditions are tightening.

As I wrote in early March, it's not just interest rates affecting valuations. Historically, U.S. equity multiples have been driven by a broader array of financial market conditions. These have become even more important in the post-crisis environment. For investors, the challenge is not simply that rates are going up; more recently, the dollar has been strengthening as well, further tightening financial market conditions.

2. Volatility is higher.

In the post-crisis environment, investors are less willing to pay more for stocks when volatility is elevated. Since 2010, the level of the VIX has explained roughly 45% of the variation in U.S. equity multiples. Put differently, a higher multiple is harder to sustain in a more volatile environment. In 2017, the VIX averaged 11. Since early February, the average daily reading

This article was written by

Russ Koesterich, CFA profile picture
Russ Koesterich, CFA, JD, Managing Director and portfolio manager for BlackRock’s Global Allocation Fund, is a member of the Global Allocation team within BlackRock's Multi-Asset Strategies Group. He serves as a member of BlackRock's Americas Executive Committee. Mr. Koesterich's service with the firm dates back to 2005, including his years with Barclays Global Investors (BGI), which merged with BlackRock in 2009. He joined the BlackRock Global Allocation team in 2016 as Head of Asset Allocation and was named a portfolio manager of the Fund in 2017. Previously, he was BlackRock's Global Chief Investment Strategist and Chairman of the Investment Committee for the Model Portfolio Solutions business, and formerly served as the Global Head of Investment Strategy for scientific active equities and as senior portfolio manager in the US Market Neutral Group. Prior to joining BGI, Mr. Koesterich was the Chief North American Strategist at State Street Bank and Trust. He began his investment career at Instinet Research Partners where he occupied several positions in research, including Director of Investment Strategy for both U.S. and European research, and Equity Analyst. He is a frequent contributor to financials news media and the author of two books, including his most recent "The Ten Trillion Dollar Gamble."Mr. Koesterich earned a BA in history from Brandeis University, a JD from Boston College and an MBA from Columbia University. He is a CFA Charterholder.

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