Some are interpreting the 9% bounce off of the 1812 lows for the S&P 500 as a sign that all is right with stocks once again. Indeed, many may view the S&P 500 trading at 1978 on the first day of March as a pretty good deal relative to where the benchmark began the year (2043). Yet the number of wrenches in the mountain bike wheel – fundamental valuation levels, historical price movement, global economic weakness – is likely to cause injury for the unprotected rider.
In recent commentary (Are Stocks Cheap Now? Get GAAP If You Want To Get Real), I discussed the significance of the differential between a non-GAAP P/E of 16.5 and a GAAP-based P/E of 21.5. That was with the S&P 500 trading at 1940. At 1978, the less manipulated GAAP-based version of reported earnings clocks in at a P/E of 22.
It gets worse. According to J.P. Morgan Chase, “pro-forma” non-GAAP earnings estimates have already dropped 6.2% for year-end 2016. The fact that they have dropped further than the market itself – roughly 3.2% through March 1 – means that stocks are more expensive today that they were at the start of the year. With respect to manipulated non-GAAP earnings, then, the S&P 500 at 1978 represents a Forward P/E of 17.
Fundamental overvaluation rarely matters until it does matter. In particular, consecutive quarters of declining earnings per share (EPS) typically weigh on the price that the collective investment community is willing to pay for S&P 500 exposure. For example, according to Dubravko Lakos-Bujas at JP Morgan, there have been 27 instances of two consecutive quarters for EPS declines since 1900. An economic recession came to pass on 81% of those occasions.
The S&P 500 has already contracted for three consecutive quarters. What’s more, according to FactSet, first quarter profits for 2016 are likely to fall 6.5% and second quarter earnings are likely to retreat 1.1%. That will mark 15 months of decreasing profitability.
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