While US equity markets have struggled to maintain consistent upward momentum roughly halfway through 2018, the underlying earnings that ultimately drive equity valuations have received a boost thanks to decent GDP growth and a pro-business administration, highlighted by the recent corporate tax cut legislation. On a trailing twelve-month (TTM) basis, S&P 500 reported earnings are anticipated to rise 9% in Q2 to a forecasted $125. Analysts believe the TTM growth rate will then continue at 8% and 10% in Q3 and Q4 of 2018, respectively.
While equity markets have been spooked by geopolitical events, interest rates, trade war concerns, and fears of an overheating economy at various times this year, the single most important factor in equity market valuation – earnings data – suggests continued fundamental strength. For investors questioning if the bull market can continue for the next several years, or whether now is a good time to initiate new equity positions, the underlying trend in earnings growth suggests the answer is yes. In the below chart, we plotted the relationship between the historical S&P prices and the reported TTM earnings. The bars in purple reflect earnings estimates, using analysts’ projections through 2019 and then applying a 2% quarterly growth rate, approx. 8% annual earnings growth, in 2020. It is apparent that barring some major unforeseen event, equity markets are likely to continue their ascent thanks to the recent explosive earnings growth.
It’s common practice in the financial industry to attempt to use the price and earnings data to pinpoint a “fair value” for the S&P 500 or other equity index (see our discussion earlier this year “Volatility Returns Update – Finding Fair Value”), and depending on measurement techniques and type of earnings data used, one can argue for over or undervaluation at any given moment. Rather than get caught up in another valuation exercise, it’s always important to look at the big picture. Growth in earnings will translate into growth in equity valuations. We are currently experiencing historically strong earnings growth coupled with a strong pro-business political environment and the projected growth rates reflect this. It’s highly likely that the remarkable equity bull run still has some gas left in the tank.
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