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S&P 500 Earnings Rebound Slightly in Second Quarter

October 06, 2016

One of the major market themes of the past 18 months has been the decline in corporate earnings. The trailing four-quarter earnings for the S&P 500 declined from nearly $106 in the third quarter 2014 to a low of $86 in the first quarter 2016. This represented a more than 18% decrease in annual earnings over a one and a half year period, returning earnings to their level from the third quarter 2012. In other words, earnings growth was flat over a four and a half year period.

The decline in earnings was the result of several major trends. For example, the decline in the price of oil and other commodities caused the earnings of energy and basic material companies to decline. In addition, the increase in the value of the U.S. dollar during 2014 and 2015 caused the earnings of US multinational companies to decline. When their foreign earnings were converted into US dollars, the unfavorable exchange rate reduced the profit in dollar terms. This weighed on the earnings of companies with significant exposure to foreign markets.

However, the earnings losing streak was broken in the most recent quarter when the second quarter 2016 earnings came in 2.1%  higher than  the same  quarter a year earlier.  

The slight earnings rebound was partly due to a rebound in oil and other commodity prices, which benefited the earnings of energy and basic material companies. In addition, stock buybacks have continued to allow earnings to outpace sales growth as companies divide their total earnings by a reduced number of shares, causing the earnings per share to increase.

The decrease in reported earnings has caused stock market valuations to soar, becoming less attractive by historical standards. For example, the price-to-earnings ratio (PE ratio) for the S&P 500 was 19.01 in the middle of 2014, well above the long-term average of 15. But as the S&P 500 value trended largely sideways over the past two years while earnings declined, the PE ratio increased substantially, reaching 25.10 for the second-quarter 2016. To put this in perspective, should the PE ratio of the market revert to its long-term average of 15, the value of the S&P 500 would have to decline 40%.

So while the decline in earnings may be over, or at least has stalled for a time, the overvaluation of the stock market has not only persisted but has actually become worse.

There are two ways that this overvaluation of the stock market can be corrected. One is for stock prices to decline so that they are in-line with their historical relationship to earnings. The second is for earnings to increase significantly so that they once again justify current stock prices. The recent recovery in earnings is a start to this process, although earnings will need to grow at a much faster pace than a 2.1% year-over-year increase to correct this relationship anytime soon.