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.
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.”
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.
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.