Earnings in and Valuation Levels Focus

We are early in the third quarter corporate earnings reporting cycle. As of now, about 14% of corporations have reported earnings. As we consider the continuing corporate releases, we note the following earnings context from FactSet:

“Of the 14% of companies in the S&P that have reported, 79% have reported actual EPS above estimates, which is above the 5-year average of 77% and above the 10-year average of 74%. In aggregate, companies are reporting earnings that are 6.1% above estimates, which is below the 5-year average of 8.5% and below the 10-year average of 6.8%.”

Even though it’s early, this seems like a typical if not slightly tepid earnings reporting season so far. We will watch the remainder of the announcements with interest, but don’t expect any meaningful shifts away from what we have seen so far.

The economic backdrop is constructive. GDP growth is positive. Interest rate policy is constructive. The US stock market is making all-time highs. Overall, there’s a lot to like about stocks right now.

The one area of potential caution rests in stock valuation levels. The S&P 500 Shiller CAPE Ratio current level is 35.23, up from 35.01 last month and up from 29.80 one year ago. This is a change of 0.64% from last month and 18.22% from one year ago. Here is a picture of current CAPE valuations relative to long-term trends.

Stocks have only carried higher valuations than this on two occasions: 1) in the 1999-2000 dot-com bubble, and 2) In the period just following the covid-recovery economic stimulus period. In both cases, stocks experienced some tough sledding afterwards.

Stock markets have quickly recovered since the 2022 sell-off and are now once again moving aggressively higher. These valuation levels certainly don’t bring any comfort to us. When we see valuation levels like this, we acknowledge that there is a higher probability of a price correction and/or a sideways market for a prolonged period as we wait for company fundamentals to “catch up” to their valuations.

As we have said frequently, we don’t have a crystal ball and we acknowledge bull markets can continue to surprise to the upside. But we can’t argue with taking some profits in highly priced stocks and moving into those stocks with more reasonable valuations.

DISCLOSURES

The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. The S&P 500 index is regarded as one of the best gauges of prominent American equities’ performance, and by extension, that of the stock market overall.

The S&P 500 Shiller CAPE Ratio, also known as the Cyclically Adjusted Price-Earnings ratio, is defined as the ratio the S&P 500’s current price divided by the 10-year moving average of inflation-adjusted earnings. The metric was invented by American economist Robert Shiller and has become a popular way to understand long-term stock market valuations. It is used as a valuation metric to forecast future returns, where a higher CAPE ratio could reflect lower returns over the next couple of decades, whereas a lower CAPE ratio could reflect higher returns over the next couple of decades, as the ratio reverts back to the mean.

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