Here’s a quick look at they key trends in US earnings revisions. For anyone who’s been living under a barrel, there has been a slump in US earnings over the past year (driven by the commodity/oil crash, US dollar surge, and slowdown in emerging markets). Given markets had only a relatively minor correction this has resulted in a rise in any valuation metric tied to earnings (i.e. PE ratios). Thus at this juncture the path of earnings is critical.
1. S&P 500 PE ratios
As noted, given the slump in earnings and lack of a major slump in stock prices, S&P500 PE (price/earnings) ratios have risen to levels only seen just prior to the dot com boom. Both trailing 12 month earnings and forward earnings PE ratios are elevated vs history, but are still yet to reach the dot com bubble mania extremes of high valuation.
2. Earnings growth
The graph of earnings growth (actually the 12 month % change in forward earnings) below shows how earnings went into a slump, but didn’t quite collapse the way they did during the early 2000’s recession or the global financial crisis. The key now is whether earnings continue to stagnate or rebound, and the answer will have an important bearing on how over- or under- valued equities really are.
3. Revisions indicator
So it will pay to keep an eye on earnings revisions. This earnings revisions indicator takes the average of a z-score of the earnings revisions ratio (count of upwards vs downwards revisions) and a z-score of the 3-month change in forward earnings. This combines the two metrics so as to capture the trend – the indicator is also smoothed (13 week average) to tune out the noise and capture the trend in S&P 500 earnings revisions. The indicator showed a calamitous decline last year, but has since rebounded. The only problem is the rebound looks fairly unconvincing at this stage.
Summary and investment implications
The overvaluation of equities is a hot topic and just about everyone has a chart of US equities being overvalued. The reason they look overvalued is because, as I said, earnings have stagnated/slumped while prices have not really corrected in a meaningful way. If earnings were to recover and shake-off the stagnation of the past year it would change the valuation picture pretty quickly. Of course if earnings continued to stagnate or fall further a very different (worse) picture would develop.
So for US equities earnings growth is the key to living long and prosperously.
Bottom Line: S&P500 PE ratios are elevated due to the slump in earnings growth, it’s important to track earnings revisions which are currently showing a feeble rebound.