At the beginning of April, the S&P500 was trading above 1400 or more than double the valley it dug itself into three years ago. Measured from the low to the high seen this month, the S&P rose more than 110 per cent -- its best performance since 1999. Not a bad accomplishment considering that this period hasn't been the best in terms of economic fundamentals in the industrialized world.
Outside of China, India and Brazil, the major economies of the world have delivered sub-par output growth and even more worse employment growth. But that doesn't mean that the corporate sector has been dragging its heels. In nominal dollars, US corporate profits reached a record high of just under two trillion dollars -- surpassing the previous high of $1.65 trillion back in 2006. As a share of the economy, profits are a sliver under 13 per cent. This isn't quite a record, but not far off the 13.2 per cent peak at the end of 1950. This leads many to wonder why the S&P500 hasn't been able to get back to its lofty levels of 2007, let alone break into new uncharted territory above 1600.
There's no simple answer to this, but to start with, it's important to remember that stock prices are supposed to reflect expectations of company earnings down the road. Likewise, a stock index like the S&P500 should value the future stream of aggregate earnings.
But, what about the fact that corporate profits have just hit a new record high? Well an equity index, like a stock price, just doesn't represent the future value of earnings, but some multiple of those earnings. The so-called price/earnings ratio or earnings multiple has been trending down since the party days of 1999, from a peak near 30 to below 15 where it is now. Therefore, even with the level of profits higher than ever, it's not enough to offset the decline in multiples which is why we find ourselves still looking upward to past highs for the S&P.
The last major secular decline in the S&P price/earnings ratio was during the 60s and 70s (a pullback from above 20 down close to 7. That was a decline of around 70 per cent, compared to the decline of a little more than 50 per cent in the multiple from 1999 to today. Put another way, if we were to repeat the percentage drop in the earnings multiple as we saw back in the 1960-1980 period, we would have a P/E for the S&P of just below 10. Assuming no change in earnings, this would imply yet another setback for the S&P just as we've experienced since 1999. Note, the long-term average for the P/E ratio is around 16 so the bulls are technically right in saying that stocks are still relatively cheap on a historical basis.
The key variable though is where profits go over the short to medium-term. We know that it will be tough to match the year-over-year comparisons for US earnings this quarter and next for a couple of reasons. One is that general economic momentum worldwide has slowed, thanks to recession in many parts of Europe and a gearing down in China (latest GDP stats indicating growth of just over eight per cent versus the old norm of ten per cent).
Second, cost pressures are creeping in as employment increases and commodity prices rise, meaning there will be a margin squeeze if firms cannot pass on the higher costs to buyers. Unless the economic situation deteriorates, profits should be hold near current levels, but this might not be enough for bulls that are hungry for the next big driver for stocks to the upside. While we debate economic momentum in the US, how much slower the Chinese economy will become and whether the downtrend in multiples has more to go, expect to see the stock market a little more shaky in the coming weeks and months. Yep, I said it -- more volatility.