The Backward Bias in Valuations

With stocks this expensive, don’t expect much from here. Variations of this sentence have made a comeback lately, all making the same point: Lofty price-to-earnings (P/E) ratios mean middling returns at best for the foreseeable future. Some of the more alarmist chatter uses the hopelessly flawed cyclically adjusted P/E, which compares stock prices to 10 years of inflation-adjusted earnings—bizarrely constructed into backward-looking uselessness. But even more traditional P/E ratios, like the 12-month trailing and forward varieties, are getting in on the act. We see some problems with the chatter.

At the highest level, P/E ratios are backward-looking. The 12-month trailing version—stock prices divided by the past year’s earnings—is obviously so. The 12-month forward version—stock prices compared to the next year’s earnings expectations—stealthily is too. Earnings expectations may try to look forward, but they are influenced by the recent past and shift up and down with prior results. And the numerator—stock prices—is inherently a snapshot of past performance. Which never predicts.

P/E fears’ flaws are more than just philosophical. As Exhibit 1 shows, P/Es often crest near stock market peaks. That is a big reason investors dislike high P/Es. But they also tend to spike early in new bull markets, with the effect pronounced by trailing P/Es (which we use here for their longer history). As a result, drawing big conclusions from a P/E’s level alone is a fool’s errand. The fact that this bull market isn’t yet two years old, young by historical standards, gives reason to pause, in our view.

Exhibit 1: A Long Look at Trailing P/Es and Stocks

Source: FactSet, as of 6/17/2024. S&P 500 total return index level and 12-month trailing P/E ratio, monthly, 3/31/1990 – 5/31/2024.

There is a simple reason for these quirky wobbles: Earnings. People always seem to forget there is a denominator in the P/E ratio, focusing on the top half—stock prices—only. But the bottom half fluctuates, growing in bull markets and getting pounded in bear markets.

This makes P/Es messy because forward-looking stocks move first. In bear markets, stocks fall as the market prices in the increasing likelihood of an earnings downturn. That downturn usually doesn’t arrive until the bear market has been underway for some time. Sometimes, it doesn’t begin until stocks—still forward-looking—have already rebounded. In either case, though, stocks normally bounce before earnings do.

Hence, early in a bull market, you get this weird divide where stocks are rising while earnings fall. This skews P/Es—the numerator jumps while the denominator sinks. It doesn’t mean stocks are overvalued. It is just math.

This math weirdness seems like where we are today, more or less. Exhibit 2 shows P/Es again, but this time with trailing 12-month earnings per share. The bear market divergence is plain as day, as is P/Es’ history of falling as earnings recover in bull markets.

Exhibit 2: A Long Look at Trailing P/Es and Earnings Per Share

Source: FactSet, as of 6/17/2024. S&P 500 12-month trailing P/E ratio and 12-month trailing earnings per share, monthly, 3/31/1990 – 5/31/2024.

We will concede that the present still looks odd, largely due to earnings’ astronomical jump in 2021 and early 2022—and the fact that they didn’t fall much after that. They still look lofty, to the naked eye, giving the perception of limited upside. But earnings, like stock prices, aren’t inflation-adjusted. That big spike? It was inflation lifting profits and keeping them elevated once trouble set in. It doesn’t represent profits coming too far, too fast and running out of room. It is just one of many ways to see how the economy swallowed a big, one-time bulge of price increases. That has largely worked its way through the system by now, creating a new, higher base for society to continue growing from.

In any case, even with the inflation bump, earnings still haven’t recovered to prior highs. Meanwhile, stocks—yes, still forward-looking—keep charting new territory. In our view, markets are pricing in the high likelihood of more earnings growth to come, which is a solid fundamental reason for them to be up.

Forward-looking factors support more earnings growth from here. Business investment is rising, with US nonresidential fixed investment climbing 4.5% in 2023 and another 3.3% annualized in Q1 2024.^[i] Companies are plowing profits back into their core businesses, launching new projects. Even with high rates, larger firms are able to self-finance growth by tapping their robust balance sheets. Some use cash on hand, while others use their size and scale to get cheaper funding through capital markets than the banks would offer. As these funds go to new business lines, products, facilities and the like, they open new avenues for earnings to grow.

This switch from two years of defense to offense is likely only just getting underway, in our view. With high rates still dominating the conversation and valuation fears now percolating, it is also underappreciated. Unloved earnings growth is the best kind—it means stocks should have plenty of positive surprises to price in. No matter what headlines argue P/Es imply today.