S&P 500: Expectations and Valuations

The S&P 500 Index has surpassed the December 2014 highs and remains solidly above the medium-term 55-day and the long-term 200-day moving averages, which is an indication that the technical uptrend remains intact.

More Companies Beating EPS Estimates

Of the 485 companies that have reported earnings to date for Q4 2014, 76% have reported actual EPS above the mean EPS estimate and 24% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is above both the 1-year (74%) average and the 5-year (73%) average.

These stocks/companies surprised the market the most..

As a side note: the market is rewarding upside earnings surprises more than average and punishing downside earnings surprises less than average.

Falling earnings expectations

In contrast, the divergence between macro data 'dismalness' and equity price exuberance seems to widen. The disconnect between stock prices and earnings expectations has been more about falling earnings expectations than surging stock prices. Most of the decline in the expected earnings growth rates for both quarters can be attributed to analysts lowering earnings forecasts for companies in the Energy sector.

For Q1 2015 and Q2 2015, analysts are now predicting year-over-year earnings declines of 4.6% and 1.5%, respectively. On December 31, analysts were projecting growth of 3.9% and 5.0% for these same two quarters.

Trading above average

Although S&P 500 companies are surpassing earnings estimates by 3.8% valuations seem rather expensive. The current forward 12-month P/E ratio of 17.2 is now well above the three most recent historical averages: 5-year (13.6), 10-year (14.1), and 15-year (16.0).

This does not necessarily mean prices will collapse immediately. Valuations tend to drift, which means the price-to-expected-earnings ratio may go much higher.

S&P 500 & the Blue Angels

Much of the short-term volatility in the stock market is attributable to the volatility in the P/E. Earnings expectations don’t bounce around very much from week to week. They tend to be inertial and autoregressive. In other words, they tend to move in the same direction they moved just recently. When they are rising, they tend to keep rising. When they are falling, they tend to keep falling.

The ‘Blue Angels’ charts below show the S&P 500 from 2000 to now and compares it to series calculated by multiplying the weekly forward earnings data for the S&P 500 by whole number multiples from 10 to 17. These series look like the vapor trails of six Blue Angel jets flying in formation.

It’s a neat way to visualize how changes in the S&P 500 are driven by changes in forward earnings expectations versus changes in the forward P/E.

2000 – 2006:

2007 – 2012: