As you know, earnings are the foundation for the market's valuation. Traditionally, the market has traded at an average multiple of slightly less than 16x operating earnings - making it fairly valued. Today, we see that the market is somewhat overvalued relative to history and thus RAA is currently underweight traditional equities.
Over the last several years, earnings growth has consistently been downgraded as the year progressed. 2015 has been no exception. In the years 2012-15, earnings growth was expected to exceed 10% at the beginning of the year. In 2012-14, earnings growth was revised down to approximately 5% (as referenced in the chart below). In 2015, earnings growth is now negative.
Currently, S&P is expecting earnings of $106.71 in 2015. This reflects earnings growth of -5.5% when compared to 2014 earnings of $113. In addition, earnings estimates for Q4 - 2015 still appear to be inflated even at these depressed levels. As it stands now, S&P expects Q4 - 2015 earnings to be $29.32. This is 13.7% higher than the average earnings of the first three quarters of 2015. One might assume that this estimate is the result of increased sales during the holiday season, however, the 5-year average earnings growth for Q4 compared to that of the prior three quarters (for that calendar year) is -0.2%. Therefore, S&P's estimate for Q4 -2015 seems extremely optimistic - even for Santa.
Nonetheless, based on S&P's current estimate of $106.71, the market is now trading at a multiple of 19.6x. If we reduce Q4-2015 earnings estimates to the average of the prior three quarters of 2015, earnings estimates drop to $103.16. This would result in a year-over-year earnings decrease of -8.7% and would increase the market multiple to 20.3x. RAA would consider a multiple at this level to be expensive.
In addition to valuations, Fed policy will play an important role in earnings going forward. Currently, the Fed Futures market is estimating a 78% probability that the Fed will begin raising interest rates in December. Higher interest rates would almost certainly result in a stronger dollar which would hurt U.S. based multinationals. For this and other reasons, interest rates and market multiples are inversely related. Thus, as the Fed looks intent on raising rates in December, market multiples may begin to contract if the market believes the trajectory of interest rate increases are steeper than currently estimated. At this time, we expect that the Fed will increase rates slowly and methodically due to weak global growth.
As always, please do not hesitate to contact us if you have any questions.
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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.