Earnings matter

The second quarter earnings season (for period ending June 30) for companies that make up the S&P 500 index, and the Canadian S&P TSX index, will start in about two weeks. Forecasts show that earnings might actually decline, year-over-year, for the first time in seven years.

Earnings are the most important factor in valuing the stock market and individual stocks. What does a year-over-year decline mean for future stock prices?

According to a June 23 2015 S&P IQ report, (contact us for a copy), the S&P 500 earnings are expected to drop by 4.4% in 2015 compared to 2014. This is a rare instance of negative growth.

Normally the economy grows by 2-4% per year and company earnings grow a bit faster than that. In 2015, the US economy is growing more slowly than normal and earnings are flat.

The dollar amount of earnings for all of calendar year 2015 are now forecast to just match 2014. This is disappointing for market watchers who are addicted to growth, year after year. Of course a lot could happen between now and the end of 2015 to improve that result. There’s an interesting quirk in this earnings game that happens every year which is worth mentioning. Analysts usually start out the calendar year too optimistic about earnings and as results are announced analysts become more realistic. For example, six months ago in January the consensus forecast for 2015 was for 7% growth and now zero growth is predicted.

The consensus forecast for 2016 is for 12% growth in earnings. But given the pattern of reduced expectations as 2016 approaches and then quarter-by-quarter as the results are announced, the estimate is more likely to come down rather than go up.

So how will the market react to negative earnings growth?

I said above that earnings are the most important factor in determining stock market valuation. But there are other factors that affect stock prices including the price-earnings ratio. The P/E ratio is what investors are willing to pay for earnings measured by stock prices. Sometimes, when ‘animal spirits’ are running hot, investors are willing to pay more for the same dollar amount of earnings and at other times, when gripped by fear, investors prefer to pay nothing for future growth. Today investors, as a group, are quite optimistic as measured by the P/E ratio.

The current P/E ratio, according to the people at S&P, stands at 17. This number is based on the S&P 500 index divided by the forecast for earnings. So the S&P is at approximately 2100 and the earnings are forecast to be $118 for 2015 and $132 for 2016. According to S&P the average value for the P/E ratio is 16, so the market is trading slightly above the average over the last fifteen years. Abnormally low levels would be around 10 times and exceedingly high values would be anything over 20 times. So it seems that US stocks are at the high end of the range. But there are other markets in the world.

Compared to the US, European stocks are a bargain. The expected earnings growth in the EURO S&P 350 is about 8% for 2015 and 12% for 2016. This is much better than US stocks, and this is one reason why our focus is shifting to stocks listed in Europe. There is also a much better chance that growth estimates in the Euro zone might be too low, as sentiment there is more subdued due to concerns about Greece.

(Chart credit: BCA Research Inc.)