As stock prices fall today, with the Dow Jones Industrial Average (INDEXDJX:.DJI) ending a scorching 326 points lower ahead of earnings, are core valuations moving past a realistic point?  Has quantitative easing lifted stocks, and now that the spigot is beginning to tighten, are investors beginning to consider more traditional measures of valuation, such as earnings?

Earnings growth in focus

In his February 3 Equity Strategy note, Citigroup researcher Tobias Levkovich opines that 2014 could be a year in which the market is all about earnings growth.  “With valuation only moderately attractive, it seems that the heavy lifting for equity appreciation will have to come from rising profits, especially since some of the originally anticipated 2014 P/E ratio expansion got pulled forward into the latter part of 2013,” Levkovich writes in the note.

Citing the “February Chart of the Month,” (below figure 1) Levkovich notes just how far the S&P 500 (INDEXSP:.INX) has moved past earnings, comparing it on a historic basis.  “Earnings have tended to be the most correlated driver for equity price trends,” he said. “When studying the stock market’s trading patterns, there does not appear to be anything more correlated to share price development than EPS direction.”

Are Equity Valuations Out Of Line With Reality?

Considering last year’s stock price run-up, which some hedge fund managers have attributed to quantitative easing by the Federal Reserve, 2014 could be a year in which the markets catch up, digest the 2013 market rise and move back to traditional valuation methods.

“Last year’s rally reflected the lack of a discounting mechanism,” Levkovich noted.  “One of the old ‘givens’ is the adage that stock prices discount earnings in advance and that has not been true for almost two decades.”  Levkovich notes how the S&P 500 (INDEXSP:.INX) (blue line, figure 1) spiked during the tech bubble of 1998 to 2000 beyond earnings growth as P/E multiples took off.  “More recently, quarterly earnings rose for a couple of years and 2013 was the “catch-up” year as global risks abated and investors began to believe that the numbers were for real,” he said.

Is QE forcing investors to consider value?

As quantitative easing is being phased out by the Federal Reserve, this could potentially force investors to consider more traditional measures of stock market value, which could boil down to earnings analysis.  “Given all the time dedicated to determining earnings by company or index, the relationship analysis is gratifying and validates all those efforts,” Levkovich noted.  Looking forward, the analyst expects subdued growth in 2014.  “Given expected GDP growth and some scope for increased corporate margins, EPS trends should support a 7%-like stock market advance this year.”