Show Me the Earnings!

With all the debate about what type of recovery our economy will have, we’ve seen the markets clearly reflect one position: a V-shaped recovery for stocks. Since the 3/23/2020 bottom, no matter which portion of the market you look at, prices have gone up significantly. Now a lot of the attention is shifting to whether the market can keep going.

To look at that, we have to look at what makes the market move over time. If the economy grows and companies grow their earnings, we see a strong correlation with returns over time. See below:

The Stock Market and Earnings

S&P 500 Index Price and Trailing Earnings-Per-Share since 1990

Source: Clearnomics Inc., Refinitiv, Standard & Poor’s

There’s never a perfect match to the chart above, but eventually, the line of the return of the market ties to the direction of earnings. Today companies have had their earnings dramatically impacted by the recession and the proof will be in the pudding going forward. To catch up with the prices, which have recovered a lot, earnings growth must follow.

For the short-term, expect valuation numbers to go from very cheap looking before, to expensive looking (below), to eventually settling into the reality that comes our way. These numbers are vacillating so quickly because we have had an economic slowdown which was faster than any time before which caused the fastest bear market ever which turned into the fastest bull market ever. That’s a lot of rapid movement.

Valuation metrics are typically measuring the price of a stock versus another metric. Below are several measures of current valuation metrics of the S&P 500, all of which are showing as expensive currently.

Stock Market Valuations

S&P 500 Index Valuations Today, One Year Ago, and Ranges Since 2003

Source: Clearnomics Inc., Refinitiv

For these numbers above to get less expensive, one of two things must happen. Prices come down or earnings go up, which will take a recovery.

While the true shape of the economic recovery is not going to be known for quite some time, that’s not worth predicting. The jobs report last Friday was an indication that perhaps recoveries can happen faster than previously thought. However, we don’t know for sure and speed is not critical. If you believe earnings eventually get higher than they are today for companies, that means prices can continue to not only be supported at the current levels but drift higher over time as the true business recovery happens. Don’t be tricked by short-term valuation readings one way or the other. Stay grounded in the long-term fundamentals and the strength of the economy to climb back. That is what will drive your long-term success.

The S&P 500 Index includes a representative sample of the largest 500 companies in the U.S.