Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

It’s time for a critical look at U.S. corporate earnings, and not just because it’s earnings season.

As Bloomberg News reported on Friday, a growing list of money mavens including Paul Tudor Jones, Scott Minerd, Philip Yang and Larry Fink are ringing alarm bells about U.S. stock valuations. But not everyone agrees that they are too high, and earnings are at the center of the controversy.

Bull Run
Several well-known money managers are warning that stock valuations are too high
Source: Bloomberg

According to Standard & Poor's, operating earnings per share for the S&P 500 were $106.26 in 2016. Based on the index’s closing price of 2,348.69 on Friday, that translates into a price-to-earnings ratio of 22.1, higher than the average one-year trailing P/E ratio of 15.6 since 1871.

But as the bulls are quick to point out, stock prices are concerned with future earnings, not last year’s. Based on the S&P 500’s expected earnings of $146.36 for 2018, the P/E ratio is a reasonable 16.1.

And herein lies the controversy. Earnings for the S&P 500 have grown 4.9 percent annually since 1929, while GDP has grown 6.1 percent. It makes sense that EPS growth should be somewhat lower than GDP growth over long periods. As William J. Bernstein and Robert D. Arnott pointed out in a 2003 study that examines the relationship between the two, “the growth of existing enterprises contributes only part of GDP growth.” 

Not Keeping Up
Earnings per share growth has historically lagged behind GDP growth
Sources: Federal Reserve Bank of St. Louis, S&P, Robert Shiller
Note: Indexed to 100.

Consider what’s happened since the financial crisis, however. Earnings have grown 10 percent annually since 2008 -- double the historical growth rate. Granted, earnings were depressed during the crisis, but GDP has grown just 2.9 percent annually since then. It’s unrealistic to expect that EPS growth will continue to outpace GDP growth by 7 percentage points a year.

No Limits
Earnings growth has far outpaced GDP growth since the 2008 financial crisis
Sources: Federal Reserve Bank of St. Louis, S&P
Note: Indexed to 100.

Nonetheless, analysts are doubling down. They expect earnings growth of 22 percent in 2017 and 13 percent in 2018, which would further stretch earnings growth to 11.4 percent a year from 2009 through 2018.

In that light, the S&P 500’s seemingly benign P/E ratio no longer seems very comforting. In fact, if earnings growth since 2008 had approximated the long-term annual growth rate of 4.9 percent -- which would still be well above GDP growth during the period -- EPS for the S&P 500 would have been $72.59 in 2016. And that would mean a more troubling P/E ratio of 32.4.

No wonder Jones and company are worked up, and they have reason to be.

All of this highlights the pitfalls of the P/E ratio. For starters, earnings are nearly as volatile as stock prices, which makes them tricky to pin down. The standard deviation of the S&P 500 has been 18.8 percent since 1926, while the standard deviation of earnings has been roughly the same at 16.6 percent.   

Also, earnings are most elusive during critical turning points in the market, just when investors tend to lean on P/E ratios as a barometer. For example, June 2009 turned out to be one of the best times to buy the S&P 500. But that was obscured by depressed crisis-era earnings for the year through June 2009, which signaled an elevated P/E ratio of 23.1.

Just two years earlier, in June 2007, earnings were riding a misbegotten wave of prosperity. It turned out to be a terrible time for investors, but that, too, was obscured by rosy earnings for the year through that month, which signaled a soothing P/E ratio of 16.4.

There are no perfect answers to the earnings riddle. But Ben Graham -- the father of security analysis -- spotted the problem almost a century ago and suggested an elegant solution. If earnings aren’t as good as they seem during booms or as bad during busts, he surmised, then the most reliable earnings number is an average of earnings over the entire business cycle.   

A common estimate of the average duration of a business cycle is seven to 10 years. The 10-year trailing average EPS for the S&P 500 is $89.30. That implies an earnings growth rate of 7.7 percent annually since the financial crisis -- still well above the long-term average -- and a lofty P/E ratio of 26.3.

Edge Off
Looking at earnings through a multiyear average smooths out much of their volatility
Source: S&P
Note: EPS for 2017 and 2018 are estimates.

There will always be apologists for the excesses of stock markets, and they’re often armed with agreeable looking P/E ratios. The next time some slick salesperson points to the P/E ratio and tells you it’s a great time to buy stocks, ask to see their earnings.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net