Corporate profits

Divergence between corporate earnings and stock valuations may not last

From tweets to trade wars to impeachment inquiries, 2019 has been anything but stable. The only thing that weathered the storm? The US stock market, which is up nearly 25% since the start of the year. Despite this strong performance, investors are increasingly concerned that stock prices may not be in line with company fundamentals.

Although the stock market continues to hit record highs, companies are earning less than they were five years ago, so this performance is largely due to the expansion of the P / E (see Figure 1 below) . This might be reminiscent of the tech bubble, when prices also accelerated sharply despite stagnant profits. Before the bubble burst, there were also large divergences between earnings and prices, but a sudden reversal brought stocks back to reality, and earnings quickly caught up. A similar scenario is not ruled out today, as the Shiller P / E, which stood at over 30 in November, is approaching its highest level since March 2000.

Figure 1: Price level of the S&P 500 relative to after-tax corporate profits (1970-present)

Source: Saint-Louis Fed, Yahoo Finance

Running a simple linear model, we see a close fit between corporate earnings and stock prices (see Figure 2 below). There has been a correlation of more than 92% between the variables since 1950, with a practically zero probability (P

Figure 2: Simple linear model

Source: Saint-Louis Fed, Yahoo Finance

Much of this P / E expansion can be attributed to aggressive company buyouts. According to the Goldman Sachs research team, only companies and households have been net buyers of equities since 2015, with buybacks accounting for the vast majority of demand (see Figure 3 below). If the market loses this key element of support in the future, whether due to regulation or natural causes (for example, higher prices will require more investment from an already stable profit pool), then one would expect stocks to return to more reasonable valuations.

Figure 3: Net demand for equity by category (in billions)

Going forward, the market’s reliance on buyouts without profit growth may become less sustainable as the impact of tax cuts has worn off and the global economy may head into a further downturn. Investors are faced with a difficult choice. If they stay fully invested, they run the risk of significant losses. On the other hand, if they take defensive positions, they risk leaving substantial money on the table. Tactical strategies, which aim to participate in market expansions and limit losses during prolonged market declines, can be an interesting consideration in resolving this dilemma.

Disclosure

Julex Capital Management is an SEC registered quantitative investment management firm specializing in tactical asset allocation strategies. The company offers a variety of tactical, unconstrained investment solutions aimed at providing downside risk management while maximizing upside potentials using its unique adaptive investing approach.

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