An earnings recession is not the biggest threat facing the stock market at the moment. This may seem like an intriguing claim made within a week where the largest retailers are reporting disappointing earnings and pushing retail-sector stocks.
In fact, making P / E multiplier contracts is a big culprit. To show that an earnings recession does not necessarily destroy the stock market, consider the SPX of the S&P 500,
Quarterly returns when its earnings per share (EPS) are declining. On average over the last century, according to an analysis conducted by Ned Davis Research, the S&P 500 performed well when its EPS was lower than a year earlier – not more.
The following chart summarizes what the research institute discovered. Notice that the S&P 500 has had the best quarterly returns in the past when its four-quarter EPS was 20% lower and 5% higher than a year ago. There is an inverse relationship between EPS growth and S&P 500 performance, with the exception that the EPS was less than 20% in the quarter compared to a year ago.
Can that exception apply now? It seems most unlikely. Even with the company’s recent earnings estimates declining, Standard & Poor’s estimates that the stock market’s four-quarter EPS for June 30 will be 28% higher than the June 30, 2021 total.
What is the reason for change in P / E quality?
To point the finger at the multipliers of earnings, instead of reducing earnings, I rely on nothing but simple arithmetic. At any given time the market level E equals P / E, so if earnings (E) are not to blame, the only other possibility is multiple (P / E).
Over the past year, the US stock market P / E multiple (based on 12-month GAAP EPS) has fallen from a high of 30 to a low of 20. If the multiple is fixed, the S&P 500 will be 28% higher than it is today. Years ago. In fact it is 6% less.
What is the reason for such a decrease in P / E multiple? There are many reasons, but perhaps the most important is inflation. History teaches us that the lower the inflation, the higher the P / E multiplier on average and vice versa.
This opposite interrelationship makes sense – up to a point. As many have noted in recent months, the high inflation rate means that future year’s earnings will have to be discounted at a larger rate when calculating their current value.
Yet, this argument – which is widely repeated – is only half the story. The other half, as I mentioned in a column six months ago, is that nominal corporate earnings per share increase rapidly when inflation is high. Over the past 150 years, this rapid EPS growth has largely offset the low P / E multipliers as inflation rises – leaving the stock market, on average, relatively intact during high inflation periods. This helps to explain the summary results in the chart.
Most investors ignore this tendency for rapid growth of nominal income in an environment of high inflation – a flaw that economists refer to as the “inflation illusion”. Investors are not the only ones to blame; There are also executives of the company. Factset reports that 85% of S&P 500 companies cited inflation in their first-quarter earnings call – the highest percentage since at least 2010.
Instead of blaming investors for their mistakes, they need to wager against their misconceptions. One way to do this is to place purchase orders below the market value of companies with strong earnings. To the extent that investors unjustly penalize the shares of that company, you will pick up some of them in a bargain. If so, history says that in the end you can get a good look.
Mark Halbert is a regular contributor to MarketWatch. His Halbert rating tracks investment newsletters that pay a flat fee for auditing. He can be reached [email protected]
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