In my post last week, I promised to look at whether company earnings justify the recent price run-up. I explained the mechanics of market fundamentals several times before so I won’t rehash how it works. You can take a look at an earnings primer here and a P/E multiple discussion here.
Getting back to current situation, Exhibit 1 shows the relationship between earnings (blue) and stock prices (red). It’s not a perfect correlation, but earnings do drive prices to a large extent. Now that we established a long term tendency, let’s zoom in and see what’s happened in the last four years or so (Exhibit 2). Both earnings and prices peaked in the fourth quarter of 2019, a few weeks before COVID started disrupting the global economy.
Note: When I say “earnings” in this post, I refer to the last four periods of quarterly earnings (the preceding 12 months). Technically lining up earnings and prices concurrently is not correct. For example, index price was known on December 31, 2019. However, Q4 2019 earnings were reported over the months of January, February and March of 2020 and thus weren’t known at the same point in time. Industry standard calculation does show them that way though and I don’t want to confuse things by shifting earnings back by a quarter relative to prices.
Exhibit 1 – S&P 500 Index Earnings and Price (1990-2022E)
Exhibit 2 – S&P 500 Index Earnings and Price (2017-2022E)
Exhibit 3 is another way to look at the same data and introduce P/E multiple into the equation. In the first row we have peak prices and earnings, which work out to 20.6 P/E ratio on the market. By end of March 2020, prices dropped 20% as market started frantically discounting impact of total shutdowns around the world. Meanwhile, earnings dropped “only” 12%, while P/E went down by 9% to 18.6. In a textbook illustration of the market being a forward-looking discount mechanism, both prices and P/E went up every quarter since. Earnings, however, didn’t bottom out until 2020 Q4 before starting to recover. P/E peaked at 30.7 in the same fourth quarter of 2020. By June of this year (2021 Q2), prices are up 33% from pre-crisis peak and earnings are 12% higher. Accounting for the gap between these two numbers is the P/E ratio which expanded by 19% (price change is a product of changes in earnings and P/E).
Exhibit 3 – S&P 500 Index Earnings, Price and P/E
Zooming in on the sector level, we have 2019 to present data in Exhibit 4. Technology (Apple, Microsoft), Communications Services (Google, Facebook) and Consumer Discretionary (Amazon, Tesla) are leading the price gains as I noted in the last post. Economically-sensitive Financials and Materials have the best earnings growth since 2019. Energy and Utilities, meanwhile, haven’t been looking too good.
Exhibit 4 – Sector Earnings, Price and P/E Changes
So there you have it folks – strong recent returns ARE a combination of earnings growth (expected to remain robust in the next few quarters as shown in Exhibit 2) and investors’ willingness to pay more for each dollar of those earnings (likely helped by Fed policies and lack of attractive alternatives). If we just read the headlines, the market seems oblivious but the actual numbers back up its rise – people are buying lots of stuff (if they can find it).