Despite unusually high expectations, companies are actually delivering on first quarter earnings. Roughly halfway through reporting season, 74% of companies reporting sales and 79% reporting earnings are beating expectations, both above the five-year average. Still, the market cannot get out of its own way. The S&P 500 Index remains nominally down year-to-date.
Why are investors ignoring strong earnings?
The simple answer is they’re not. Instead, the answer lies with stretched valuations and changing economic and financial market conditions.
After peaking at nearly 23.5, an eight-year high, in late January, the trailing price-to-earnings ratio (P/E) of the S&P 500 fell roughly 14% to below 20 (see Chart 1). While valuations have recovered a bit in recent weeks, the trailing P/E on the S&P 500 remains below where it started the year. After more than seven years of relentless multiple expansion, investors seem to be reconsidering paying ever more for a dollar of earnings. While the most obvious culprit is higher interest rates, the reasons for lower multiples are more nuanced. They include:
1. Financial conditions are tightening.
As I wrote in early March, it’s not just interest rates affecting valuations. Historically, U.S. equity multiples have been driven by a broader array of financial market conditions. These have become even more important in the post-crisis environment. For investors, the challenge is not simply that rates are going up; more recently, the dollar has been strengthening as well, further tightening financial market conditions.
2. Volatility is higher.
In the post-crisis environment investors are less willing to pay more for stocks when volatility is elevated. Since 2010, the level of the VIX has explained roughly 45% of the variation in U.S. equity multiples. Put differently, a higher multiple is harder to sustain in a more volatile environment. In 2017 the VIX averaged 11. Since early February, the average daily reading has risen to 17.5 This alone suggests about a 1.6 point reduction in U.S. equity multiples.
3. Growth is slipping while inflation is rising.
Apart from financial market conditions, equity multiples also tend to co-move with the real economy. Not surprisingly, historically the best combination for multiples has been strong growth and low inflation. While growth is still solid and inflation low, the first quarter witnessed a deceleration in growth and a modest acceleration in inflation. This combination creates an additional headwind, particularly at a time when multiples are already elevated.
Stronger growth and moderating inflation ahead?
The good news is that the rise in inflation is largely due to base effects, i.e. weak data from early last year falling out of the calculation. Given this dynamic, inflation should moderate by mid-year. At the same time, we’re likely to see some rebound in growth given extraordinary fiscal stimulus. Moderating inflation and faster growth should help.
That said, double digit stock gains may still be hard to come by in an environment in which investors may no longer be willing to pay any price to own stocks.