CORPORATE EARNINGS HAVE BEEN FLAT FOR MANY YEARS
The S&P 500 has become detached from underlying profits, as it did in the late 1990’s.
“Corporate profits are the mother’s milk of stock returns” is a saying that investors periodically hear repeated by market pundits. Using the Federal Reserve Bank of St. Louis’s ‘FRED database’ we can see how corporate profits have stagnated in the past yet stock prices have continued to advance (becoming more expensive) in the late 1990’s and today.
The two data sets obviously do not move in lock step, there are periods where one leads the other. The point is that when they diverge there is an inevitable draw down or catch up. Today, investors run the risk of sub-optimal investment returns, which can include a large draw down, going forward. The deviation between profits and prices does not go on forever.
Stock prices have continued to outpace profits in part due to stock buybacks. In the low interest rate environment, over the past few years, corporations have been able to issue bonds (borrow) in order to buy back billions in stock. [When corporations buy back stock the stock that they buy is ‘retired’, which means that there are fewer shares outstanding.
The result is that the remaining shares become more valuable (prices tend to go up when this happens) because there are fewer shares divided into roughly the same level of profits; so the ‘earnings per share’ grows even though the overall earnings of the corporation may not.
source: Datastream
I signed into the FRED database and ran the same data against the Wilshire 5000 Index, which is the all stock index. You can see that the same deviation exists.
source: Federal Reserve Bank of St. Louis, FRED database
We can also see this deviation between price and earnings by looking at one of the sectors that has driven stock market returns over the past decade, technology stocks by comparing the performance of the S&P 500 Information Technology Index to the S&P 500 Index.
Here we see that although technology shares have continued to outpace the broader index, since 2018, their profits have flatlined.
source: Bloomberg and Morgan Stanley Research
In this environment investors should examine their risk management procedures, for example this could including a stop loss strategy and diversification outside of the US markets.
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DEFINITIONS
FRED: Federal Reserve Economic Data – a database maintained by the Research division of the Federal Reserve Bank of St. Louis that has more than 500,000 economic time series from 87 sources. The data can be viewed in graphical and text form or downloaded for import to a database or spreadsheet, and viewed on mobile devices. They cover banking, business/fiscal, consumer price indexes, employment and population, exchange rates, gross domestic product, interest rates, monetary aggregates, producer price indexes, reserves and monetary base, U.S. trade and international transactions, and U.S. financial data. The time series are compiled by the Federal Reserve and many are collected from government agencies such as the U.S. Census and the Bureau of Labor Statistics.
S&P 500: The modern design of the S&P 500 stock index was first launched in 1957. Performance back to 1950 incorporates the performance of predecessor index, the S&P 90.
The index is a capitalization weighted index of the 500 large companies listed on various stock exchanges (such as the NYSE or NASDAQ). The S&P 500 was developed and continues to be maintained by S&P Dow Jones Indices, a joint venture majority-owned by S&P Global. The S&P 500 differs from the Dow Jones Industrial Average and the NASDAQ Composite index, because of its diverse constituency and weighting methodology. It is one of the most commonly followed equity indices, and many consider it one of the best representations of the U.S. stock market.
S&P Information Technology Index: The index comprises those companies included in the S&P 500 that are classified as members of the GICS® information technology sector.
Wilshire 5000 Index: The Wilshire 5000 Total Market Index, or more simply the Wilshire 5000, is a market-capitalization-weighted index of the market value of all US-stocks actively traded in the United States. The index is intended to measure the performance of most publicly traded companies headquartered in the United States.
IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. This memorandum is being made available for educational purposes only and should not be used for any other purpose.
The information contained herein does not constitute and should not be construed as representation or solicitation for the purchase or sale of any security or related financial instruments in any jurisdiction. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
Investing involves risks including possible loss of principal. Past performance does not guarantee future results. Any investment or investment strategy outlined herein are not suitable for all investors, readers should conduct their own review and exercise judgment prior to investing. Wherever there is the potential for profit there is also the possibility of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
This report expresses the opinions and views of the author as of the date indicated and are based on the author's interpretation of the concepts therein, and may be subject to change without notice. Neither Highcroft, Inc., Gerald Asplund, nor LPL Financial, has no duty or obligation to update the information contained herein.
To the extent you are receiving investment advice from a separately registered independent investment advisor or broker, please note that Highcroft, Inc., Gerald Asplund, and LPL Financial are not an affiliate of and makes no representation with respect to such entity.
Certain information contained herein concerning economic trends, Fundamentals, and/or Technical analysis, and performance is based on or derived from information provided by independent third-party sources. The economic forecasts set forth in this material may not develop as predicted.
Technical analysis is generally based on the study of price movement, volume, sentiment, and trading flows in an attempt to identify and project price trends. Technical analysis does not consider the fundamentals of the underlying corporate issuer.
The sources from which information has been obtained is assumed to be reliable; the accuracy of such information is not guaranteed and the accuracy and completeness of such information has not been independently verified.
All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. All performance referenced is historical and is no guarantee of future results. Investing in the index would require investors purchase an investment product, which would involve fees and expenses.
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