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A Step in the Right Direction

 

For Q1 2017, the estimated earnings growth rate for the S&P 500 is 9.1%.  If 9.1% is the actual growth rate for the quarter, it will mark the highest (year-over-year) earnings growth for the index since Q4 2013 (8.9%). 

Over the past five years on average, actual earnings reported by S&P 500 companies have exceeded estimated earnings by 2.9%. If this average increase is download.jpgapplied to the estimated earnings growth rate at
the end of Q1 (March 31) of 9.1%, the actual earnings growth rate for the quarter would be 12.0% (9.1% + 2.9% = 12.0%). If the S&P 500 index does report growth of 12.0% in earnings for Q1 2017, it will mark the highest earnings growth reported by the S&P 500 since Q3 2011.  

This is significant for a couple of reasons:

1) First and foremost, we are actually seeing earnings growth. If you read our articles regularly, you have likely noticed our concern for the lack of growth in corporate earnings.  If you recall, we have mentioned on numerous occasions that when corporate earnings do not grow and equity prices do, investors are simply paying more for equities.  From 2009-2016, over 65% of the growth in equity prices have been due to increases in valuations versus true earnings growth.  A double-digit increase in Q1 earnings growth is positive sign that earnings have in-fact returned.

2) The forward 12-month Price/Earnings (P/E) ratio for the S&P 500 is 17.5.  Meaning that on average, investors are willing to pay $17.5 per share for each $1 in earnings per share of a company. For perspective, the average P/E ratio is 15.1 and 14.0 on a 5 and 10-year basis.  As a result, it can be argued that equities are 10-20% overvalued based on historical norms.  It is worth noting that the 17.5 forward P/E figure includes double-digit earnings projections for 2017 and 2018.  Meaning that if we really experience closer to 5% growth in corporate earnings during 2017 and 2018, the true forward P/E may be well over 20.0.   For this reason, a 10-12% earnings growth number in Q1 gives us some confidence that expectations may be realistic. 

We continue to monitor and believe that corporate earnings are a fundamental "guardrail" to long-term equity prices.   Put simply, it is rare for equity prices to get extremely out-of-line from valuations. Due to the lack of earnings growth over the past three years, this market has desperately needed the validation that we hope to get this quarter from double-digit earnings growth.

 

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Reid Davis serves as a Wealth Strategist at Pinnacle Trust. He is also the Chairman of the Investment Committee.  You can reach Reid by emailing him at rdavis@pinntrust.com or by calling the office at 601-957-0323.