- Earnings estimations tell us that the S&P 500 will reach 6,471 and the Dow 59,000 points in 10 years.
- A bad case scenario with current earnings growth would see the S&P 500 at 3,589 points while the Dow, which just passed 20,000 points, would be at 31,415 points.
- We’ll compare a short-term and a long-term perspective on earnings.
- Only two times in history have valuations grown alongside earnings, and the results are extremely indicative.
Earnings are the oxygen of our investments. Therefore, it’s extremely important to keep an eye on what is going on.
A short-term and long-term perspective on recent earnings reports is going to tell us how to position ourselves for 2017 and beyond.
A Look At S&P 500 Earnings
Let’s first take a look at the reported earnings of the top 5 S&P 500 companies before looking at aggregate numbers.
Average statistics are good, but reading about specific companies gives a better feeling of how markets breathe.
Apple Inc. (NASDAQ: AAPL) reported tremendous earnings per share (EPS) of $3.36, and revenue growth of 3.3% to $78.4 billion for the recent quarter, beating estimated EPS by $0.14 and revenue by $1.04 billion.
Amazon.com Inc. (NASDAQ: AMZN) saw sales increase 27% in 2016 and earnings quadruple.
Johnson & Johnson (NYSE: JNJ) reported sales growth of 2.3% and earnings growth of 8.5% in 2016.
With the exception of Exxon which has seen earnings decline due to lower oil prices, all of the companies listed above saw revenues and earnings grow in 2016. Revenue and earnings growth in the range of 2% to 8% are amazing accomplishments for stable and large companies. What AMZN is doing with revenue growing 27% is off the charts and can’t be appraised with normal business or valuation models.
What’s important is that as long as the economy continues to grow, with low inflation and new jobs being added, we can expect earnings to continue growing at the rates described above. Stable companies will grow between 2% and 5% while growth companies will aim for double digit growth rates.
Declining unemployment increases personal income and spending which further fuels the growth part of the economic cycle and earnings.
Figure 1: Unemployment rate and change in employment. Source: Bureau of Labor Statistics.
On the aggregate, earnings don’t differ much from the individual companies described above, with some companies growing extremely fast like AMZN and other industries passing through difficult times like mining, shipping, energy, retail etc.
Available data from 55% of S&P 500 companies that have reported earnings to date shows an aggregate earnings growth rate of 4.6% in the last quarter of 2016. This is an extraordinary number. If earnings continue to grow at such a rate for the next 10 years, with equal valuations, the S&P 500 would be at 3,589 points while the Dow, which just passed 20,000 points, would be at 31,415 points.
Such levels seem impossible to reach, but the market seems to believe it as it is willing to pay a 25.7 valuation for the S&P 500.
Figure 2: Historical chart of the S&P 500 price earnings ratio. Source: Multpl.
Analysts are even more positive and expect S&P 500 earnings to grow 11.2% in 2017 and 11.6% in 2018.
Figure 3: S&P 500 earnings estimates. Source: FactSet.
If earnings grow at 11.4% for the next 10 years, with current valuations the S&P 500 would go to 6,741 points and the Dow would be at 59,000 points. Is this possible?
The answer, and you might be surprised,is yes.
Something that will surprise you even more, it doesn’t have to take 10 years. It may take only 5 years for the Dow to reach 60,000. I have learned one thing in the many years since I follow financial markets, anything is possible.
If earnings continue to grow at the rates described above, more and more investors will get into the market expecting consistent earnings growth and willing to pay whatever valuation. A booming stock market attracts new market entrants which further increase demand for stocks and valuations, pushing indexes to unbelievable new highs.
As long as the economy continues to add jobs and grow, everything is possible. However, it’s also necessary to take a look at the long-term perspective on earnings.
A Long-Term Perspective
Plotting short term earnings growth and economic growth into longer periods is what excites many unexperienced investors. However, I have this sense of responsibility forcing me to show some additional historical facts in order to put things into perspective.
By taking another look at figure 3, you can see that S&P 500 earnings in 2007 were at 81.79 points, while earnings for 2016 were at 118.80 points. This results in an annual growth rate of 4.2%. Which is a great growth rate, but I have to spoil this one too. In the last 9 years, interest rates have been at zero for most of the time, so that growth was easily obtained by issuing debt used for mergers and acquisitions and especially buybacks.
The net debt issuance chart below will show that most of the S&P 500 earnings are to be thanked to low interest rates. In the last two years have S&P 500 corporations borrowed a record net amount of more than $800 billion, or 4% of their market capitalization.
Figure 4: S&P 500 net debt issuance/reduction (millions). Source: FactSet.
Apart from the debt chart, I have an even scarier chart.
I have plotted S&P 500 earnings and the respective PE ratio since 1950. Only three times in this period have valuations grown alongside earnings, in the 1950s up to 1956, before the dot-com bubble, and now.
Figure 5: S&P 500 earnings and PE ratio. Source: Multpl.
Unfortunately, in the periods that followed the first two instances—1950 – 1956, and 1995 – 2000—the growth results were abysmal. This tells us that extrapolating a growth rate for the period following the one we’re in now, 2011 – 2016 on the chart above, won’t give us a realistic result.
At the end of 1956, the S&P 500 was at 48.49 points. Four years later, the S&P 500 had barely grown and was just 56.8 points. And in January 2000, the end of our next period where the growth of earnings and valuations were correlated, the S&P 500 was at 1,425. By January 2010, it was at 1,123.
So if we think about where the S&P 500 will be in 2027 by extrapolating into the future after this period when valuations have grown alongside earnings, will we be at 2,000 or 6,000 points? Nobody knows for sure, but history suggests it will be closer to 2,000 than to 6,000.
What To Do?
First, forget about stocks and think like a business owner. Would you be happy owning the business behind the stocks you own and live off dividends, or, would you quickly sell your company to the highest bidder on the stock market?
Second, look at the economics and what the FED has to say. If interest rates go up, companies will be disabled from borrowing more and will have to pay more interest, lowering earnings. Avoid companies with high debt levels.
Third, remember that in the long-term, corporations and earnings will grow alongside economic growth. Therefore, looking at emerging markets might be a smart idea now that the dollar is strong and nobody has yet to recognize that earnings and economic growth are fueled by debt. Unfortunately, sooner or later, the debt party will have to end, as it always has in the past.
Fourth, find stocks backed by great businesses at low valuations. With lots of research, it’s possible to find gems as today you can buy stocks all around the world.
Fifth, keep reading Investiv Daily.
Our goal is to help you position yourself so that if the Dow goes to 60,000, you enjoy the ride too, and if the Dow goes to 10,000, you don’t lose 50%.