Weighing The Week Ahead: Can Earnings Growth Justify Current Stock Prices?

Theme and comment

The successful development of vaccines in record time regardless of delays and rates of cooperation. The economy has turned sluggish, but not to worry. Stimulus is on the way.

Most investors have experienced a time where skepticism about forward earnings was standard practice. Looking only at past earnings, markets seemed perpetually expensive.

Investors now have a new sense of optimism. They are looking beyond near-term events and peering into the future, perhaps well into the future. It raises a crucial question:

Can corporate earnings grow enough to justify current stock prices?

Background

Opinions about whether the market is cheap always inspire intense debates with more heat than light. When a valuation measure does not seem to “work” then the adherents trot out a parade of excuses. A favorite is that valuation is a poor timing method. Let us take a closer look.

J.P. Morgan’s excellent Guide to the Markets is published quarterly but updated even more regularly. It is a treasure trove for the data-driven investor. Here are two important charts. The first shows that it matters little which valuation measure you pick from among the most popular choices.

I prefer the (unpopular) forward earnings approach. Here is a look at that. There is a wide variation and low correlation for the upcoming one-year return, but a solid relationship over five years.

Left out of this is the effect of extremely low interest rates. For years, the reliably bearish portion of the punditry contended that this was irrelevant. Then it became a Fed-manipulated TINA (there is no alternative) which created artificial euphoria. Even Prof. Shiller (more than a little late to this party) is out with new research suggesting that perhaps an extra equity premium is deserved when interest rates are very low.

The result is a valuation gap: Either stock prices are too high or expected earnings are too low. FactSet provides a great chart of the history over a decade.

Gap Example

The problem is best illustrated through a specific typical case. In my constant search for stock ideas, I have seen hundreds of charts like this one. My example is drawn from Chuck Carnevale’s excellent FASTGraphs tool. This is part of my stock analysis for every name that I consider. It is the most efficient method to get the key data a fundamental investor need. And it even lets you alter various key assumptions.

Please note the similarity with FactSet’s chart of the overall market. Caterpillar is a great company.

  • Earnings are growing throughout a business cycle.
  • Debt is reasonable and the credit rating is excellent.
  • The company is a dividend aristocrat, (Barron’s) having increased the dividend for 25 straight years.
  • Investors are enthusiastic about the company’s role in a possible infrastructure program.

All good. That said, in seventeen years the company has never had earnings high enough to justify the current stock price. If the multiple would revert to normal levels, the stock would fall to about 82. For earnings to grow enough to validate the current price one must look beyond the 2022 estimates – perhaps well beyond. It is a long time to wait.

Looking Across the Economic Valley

Barron’s reports, Earnings Season Is About to Begin. Investors Are Already Looking Past itRead the entire article to see the discussion of data and stocks, helped by “ultrasupportive monetary and fiscal policies.”

In sharp contrast, Carmen Reinhart, chief economist of the World Bank, covers many crucial points in her interview with Leslie P. Norton of Barron’s. And yes, she is the co-author of the influential book warning about debt, This Time Is Different: Eight Centuries of Financial Folly.

How many countries have gotten back to their pre-crisis level of per capita income? We’re not there yet. Let’s take a standard, well-known global forecast, like the World Economic Outlook from the International Monetary Fund, or the Global Economic Prospects from the World Bank. Both projections, even with a V-shape rebound, still don’t get you to your pre-crisis per capita income level. That takes longer. If you look at past serious crises, that full recovery, getting back to, at a minimum, where you were before the crisis hit, is a multiyear process.

Don’t confuse rebound with recovery. We’re going to see this snapback, because we had output and employment collapses the likes of which are four standard deviations and more away from any normal downturn. The temptation is to say, aha, we’ve recovered. Not the same thing.

And further…..

In the U.S., some of the risks to recovery are declaring victory prematurely and withdrawing stimulus prematurely. To get recovery on a sustained footing, we still need to see more fiscal stimulus. Good news on the vaccine notwithstanding, we are still seeing record infection rates.

Let me highlight another headwind to growth. By almost any realistic assessment, the issue we are looking at is more nonperforming loans. You don’t get this kind of economic contraction and not affect household and business balance sheets. What do financial institutions do when they’re facing compromised balance sheets? They curtail lending. This was a classic case in Europe after the 2008-09 crisis. In varying degrees, you’re going to see tighter lending standards, less new lending in an environment with so much uncertainty.

Another conclusion offered by UPFINA.

Will 2021 Be The Year Of Multiple Contraction?

2021 is starting off with important news on vaccines, the elections, and stimulus. 2020 had the biggest drawdown in a positive year ever. 2021 is set to have strong EPS growth, but multiple contraction will probably limit the potential gains. We might even see losses even with +20% EPS growth. Despite the weakness in mobility, the NY Fed’s weekly economic index and the ECRI leading index show better growth. Goldman is forecasting higher 2021 GDP growth because of the stimulus. If another one passes, growth could be even higher which would probably also lead to excess inflation.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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