Earnings & Stock Price Mismatch

EPS growth and stock prices don’t always match if you’re looking at data by year. As you can see from the table below, in 3 out of the 7 years EPS fell, stocks were up. In 5 of 9 times the stock market fell, EPS growth was positive. We will likely see very strong stock price growth and weak returns in 2021.  

If you take a longer-term approach, you can see the relationship between EPS and returns better. One inkling is to believe optimism about a cyclical recovery causes stocks to rise as earnings are falling. When earnings are strong, sometimes it’s tougher to have solid growth.

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The chart shows EPS growth went on a few runs of double-digit gains. 10 out of 16 times S&P 500 EPS growth was double digits, it rose 10% or more again the next year. Sometimes investors sell stocks because they are scared of a negative catalyst that ends up not causing as much damage as expected. 

For example, investors sold stocks before the 2020 election. That wasn’t enough to make the year negative, but it’s just an example. The selling at the end of 2018 made the year negative. It caused the Fed to get more dovish, which helped set the scene for 3.6% EPS growth in 2019 which isn’t that bad. The stock market’s decline actually had a positive impact on earnings in that scenario.

Expectations determine stock prices more than earnings themselves. Of course, if a company’s results are different from expectations, reality usually takes control. In that situation, there is a re-rating. That’s when investors take a new look at the company which causes its stock price to change rapidly. The stock market has largely been increasing since 1989 which is why the table shows there were 21 years of multiple expansion and only 11 years of contraction.

In 6 of the 11 years of contraction, stocks were up because EPS was up more. This year had the greatest multiple expansion ever at 51.2%. The 2^nd best was in 1991. There were 3 straight years of multiple contraction following 1991. We will likely see this again in the next few years. And we could see a 20% EPS gain and a 5% decline in the index in 2021.

Economic Update

Some of the economic measurements aren’t in disaster mode like the one measuring mobility. As you can see from the chart below, the NY Fed’s weekly economic index is continuing to show better growth. In the week of December 26^th, the yearly growth rate improved to -1.32% from -1.95%. 

The 2-week lull where growth fell ended with the past 2 weeks of improvement. The weekly leading index’s growth rate surpassed its 13-week average in the week of June 6^th and never looked back. That’s ironic because in early June we saw peak optimism on the economy. We didn’t get that optimism back until early November when the positive vaccine data came out and we had the election.

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The ECRI leading index was updated on Thursday as well. The index rose from 147 to 147.5. I think it is being helped by the stock market and commodities prices. The growth rate spiked to 15.2% from 14.5%. Everyone is expecting a massive year for the economy. 

The virus will be contained and the stimulus will spur growth. 2020 was a terrible year, yet we are ending it with a lot of optimism. That’s despite the fact that there are record high hospitalizations and there will be a lot of deaths in January. We might even see more deaths next month than this one.

Finally, the NY Fed’s GDP Nowcast was also updated. It is way too negative on Q4 GDP growth. Its estimate rose 9 basis points to 2.05%. Q1’s growth is modeled as being 5.22% which is a 13 basis point improvement from last week.   

Tobacco Is Very Cheap

The yearly PE ratio for most industries rose. The oil and gas refining PE ratio actually increased 896% because of its decline in earnings. The S&P 500 had a 22% increase in its PE ratio to 22.2. Only a few industries saw declines in their PE ratio. Of course, you can’t just buy industries that got cheaper. 

However, in the case of tobacco, it makes sense because its earnings are so stable. US smoking falls almost every year, but price increases push earnings up. The tobacco industry’s PE ratio fell 9.4% to just 12.2. In an expensive market, this is very cheap. This was actually a good year for tobacco because regulations and health scares pushed people away from vaping and back to cigarettes.

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As you can see from the chart above, there is a massive difference between the price of tobacco bonds and their stocks. Obviously, there is an ESG shift that is pushing people away from tobacco. However, these companies have high yields which should bring people in. 

Furthermore, ethics doesn’t seem to be stopping people from owning the debt. Tobacco stocks are sort of like bonds except their earnings grow and they offer much higher yields. This is one of the last vestiges of high yields and low valuations.

Some investors own Altria which is a special situation within the industry because it is hated more than the others for its expensive acquisition of Juul. Being the ugliest duckling of a hated group gives it an above 8% dividend yield.

Conclusion

EPS is likely going to rise sharply in 2021, but stocks will pull back especially the overvalued names such as Tesla. We will see a multiple contraction that makes stocks cheap again. Given the spike in EPS that’s coming, even a 10% rise in stocks will make them cheaper on a trailing basis. 

The ECRI leading index and the NY Fed’s weekly economic index showed improvement in December. Tobacco stocks are very cheap. They are hated for ethical reasons, but their bonds are still getting capital. Many think they will outperform in 2021, with Altria doing particularly well.