Earnings Are the Key

The main story is the strength of corporate earnings. The adjacent graph shows that the growth rate of corporate profits over the last five years has been incredible. In fact, the growth rate has been double digit for the last seven quarters. Even more interesting is that these record profits are not fully reflected in stock prices.

The next graph below shows the performance of the S&P 500 from 1996 through First Quarter 2007. It shows the ride up to the top of the dot-com bubble; the subsequent bust and the climb back up. Although close, the S&P 500 has still not exceeded its previous high (as of quarter end) even though the index is up 83% from its low. Stocks are significantly cheaper than on March 24, 2000 based on P/E ratios (for explanation of P/E ratio see below). In fact, stocks are 43% cheaper than from previous high.

The P/E Ratio
P/E is the ratio of Price to Earnings. The price of a stock is a function of the underlying earnings and the P/E multiple captures that relationship. The ratio shows the embedded cost for every dollar of earnings the stock is generating. In other words, if the P/E ratio is 30 then you are paying $30 dollars for every dollar of earnings.

Why isn’t the current high earnings growth rate fully reflected in current P/E ratios? Because built into P/E ratios are future earning expectations. Current stock valuations anticipate the slowing of earnings growth rate to rates closer to the historic norm from the current extraordinary levels. The market does not believe this elevated rate of earnings is sustainable in the long run. In addition, the market is building a margin of safety lest inflation doesn’t moderate and the Federal Reserve has to raise interest rates again. It is factoring in all potential risks and discounting stock prices to reflect this increasing volatility. Usually big market declines are generally preceded by stretched valuations. It is comforting to know that even though the markets were more volatile this quarter, valuations are reasonable.

However, valuations are stretched in some segments of the market, like mid and small caps (Russell 2000 index). These smaller caps have outperformed large caps for years but as a result valuations are pushed. Russell 2000 index has a high P/E ratio of 38.7 which implies a 63% earnings growth rate. It is doubtful that small caps will be able to de-liver such a strong performance forever. Conversely, the Nasdaq has a negative implied earnings growth rate. The market expects the earnings of Nasdaq-high tech stocks to contract. Growth stocks have underperformed value stocks since the dot-com bust but it is unlikely that this underperformance will last forever.