Size
In the case that the specific group of equities that make up the S&P 500 account for a larger share of production, we would expect those equities to command a higher multiples in the case that those companies hold a larger “market share” of overall production. A higher proportion of revenue to U.S. GDP should command a higher multiple, and vice versa. So at historically higher P/E ratios, we should find a growing proportion of corporate production to GDP. On the contrary: Sales per share, going back to December 31, 2000, have been retreating relative to GDP. In fact, sales have decreased rather steadily as a percentage of GDP (quoted in billion of Dollars). This should put negative pressure on the allowable market P/E multiple.
Risk
As a stand-in for risk, we analyzed market profitability metrics, comparing quarterly EPS to quarterly revenue per share and finding out where the net profit margin of 8.3% as of December 31, 2016 compares to historic levels. As it turns out, it fall within the average (7.8% is average to be precise), and with maximum historic profit margins of 10.5% and minimums of 0.7%, this metric does nothing to convince us that investors should be paying higher prices per earnings on a macro scale.
Growth
Before looking at the forward year EPS projections (provided by Y-Charts), it became clear to us that the single driving force for market expectations rests solely on the expectation of huge growth. While revenue per share has grown at a compound annual rate of 2.8% since 2000, net income has grown by about 2.5% since then. On the contrary, in the following four quarters from today, S&P 500 earnings are expected to grow to $126.6/share.
These projections would put us at 25.6% higher than our current TTM EPS, and 19.5% higher than the highest EPS ever reported. That’s not a rounding error, that’s a massive difference. We would be willing to pay 25x earnings if companies are truly expected to be this profitable this year. These numbers would bring the S&P price levels as of 7/30/17 down to 19.5x P/E, or 20.9x P/E when factoring in the expected annual appreciation of about 7.2% to S&P 500 price levels.
As an understatement, those are monstrous projections of earnings, without considering the factors that went into projections. So in other words, the math makes sense, and the earnings multiples do appear to be justified should the S&P 500 increase EPS by 25% over the next twelve months.
Growth levels that large tend to happen, from what we have seen, following a depressed period of activity, when companies operate at much lower than desired levels of capacity for one to two-years followed by a burst of activity. But we can see that this isn’t the case now, in what is the slowest but steadiest economic expansion period in American history.
We would prefer to err on the conservative side, and will tread lightly in our stock selection with built-in margins of safety. Valuations built on such aggressive assumptions can be fragile. We plan on keeping our ideal portfolio allocated at 80% equities and 20% investment grade bonds, and will most likely adjust to a 60/40 split as this bull market continues to heat up over the next two years. To be fair, we think the probability that corporate earnings will live up to expectations is greater than the probability that they won’t. And we believe it is worth the risk.
In the case that the specific group of equities that make up the S&P 500 account for a larger share of production, we would expect those equities to command a higher multiples in the case that those companies hold a larger “market share” of overall production. A higher proportion of revenue to U.S. GDP should command a higher multiple, and vice versa. So at historically higher P/E ratios, we should find a growing proportion of corporate production to GDP. On the contrary: Sales per share, going back to December 31, 2000, have been retreating relative to GDP. In fact, sales have decreased rather steadily as a percentage of GDP (quoted in billion of Dollars). This should put negative pressure on the allowable market P/E multiple.
Risk
As a stand-in for risk, we analyzed market profitability metrics, comparing quarterly EPS to quarterly revenue per share and finding out where the net profit margin of 8.3% as of December 31, 2016 compares to historic levels. As it turns out, it fall within the average (7.8% is average to be precise), and with maximum historic profit margins of 10.5% and minimums of 0.7%, this metric does nothing to convince us that investors should be paying higher prices per earnings on a macro scale.
Growth
Before looking at the forward year EPS projections (provided by Y-Charts), it became clear to us that the single driving force for market expectations rests solely on the expectation of huge growth. While revenue per share has grown at a compound annual rate of 2.8% since 2000, net income has grown by about 2.5% since then. On the contrary, in the following four quarters from today, S&P 500 earnings are expected to grow to $126.6/share.
These projections would put us at 25.6% higher than our current TTM EPS, and 19.5% higher than the highest EPS ever reported. That’s not a rounding error, that’s a massive difference. We would be willing to pay 25x earnings if companies are truly expected to be this profitable this year. These numbers would bring the S&P price levels as of 7/30/17 down to 19.5x P/E, or 20.9x P/E when factoring in the expected annual appreciation of about 7.2% to S&P 500 price levels.
As an understatement, those are monstrous projections of earnings, without considering the factors that went into projections. So in other words, the math makes sense, and the earnings multiples do appear to be justified should the S&P 500 increase EPS by 25% over the next twelve months.
Growth levels that large tend to happen, from what we have seen, following a depressed period of activity, when companies operate at much lower than desired levels of capacity for one to two-years followed by a burst of activity. But we can see that this isn’t the case now, in what is the slowest but steadiest economic expansion period in American history.
We would prefer to err on the conservative side, and will tread lightly in our stock selection with built-in margins of safety. Valuations built on such aggressive assumptions can be fragile. We plan on keeping our ideal portfolio allocated at 80% equities and 20% investment grade bonds, and will most likely adjust to a 60/40 split as this bull market continues to heat up over the next two years. To be fair, we think the probability that corporate earnings will live up to expectations is greater than the probability that they won’t. And we believe it is worth the risk.
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