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Earnings Green Light, Valuations Red Light

By: Royce W. Medlin - Chief Investment Officer

Earnings Green Light, Valuations Red Light

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Corporate earnings signaled a green light for stocks again this quarter, marking the second double-digit growth quarter in a row which last occurred six years ago. Revenue growth has also surprised on the upside which portends good growth to come. Contributing factors include operating leverage on the back of years of cost cutting, a weaker dollar, an energy sector that has stabilized, and strong consumer spending.

Earnings gains have also been broad across sectors which is a healthy sign. This year has witnessed a change in market leadership from slow growth companies using debt to boost earnings-per-share through stock buybacks to companies that are actually investing in new plant and equipment. GDP has also picked up recently growing at 2.6% in the most recent quarter.

Earnings-green-graphicUnfortunately, stock market valuations are flashing a red light. The accompanying chart shows the price-to-sales ratio of the largest 500 companies in the US, equally weighted. Today, this measure stands at 1.6x sales, a level that is near the 30-year peak of 1.7x reached in 2007 before falling over 60% to 0.62x sales in early 2009. Looking at the equally-weighted S&P 500 gives us a broader sense of where valuations are. Note the reasonable valuation levels on this chart in 1999 and 2000, a time when tech stocks were extremely overvalued but most stocks were fairly priced. Today, most stocks are trading at high valuations relative to history which shows the breadth of the valuation problem. Price-to-sales is the most stable of the fundamental ratios since revenues are less volatile than corporate earnings and cash flow. Earnings valuations look less extreme but are also high.

Our goal at Clear Rock is to first, protect wealth and second, capture opportunities. We’re at a challenging point in the market cycle where fundamentals are good and improving but valuations point to lower returns in the coming years.  Protecting wealth becomes critical at later stages in and economic and market cycle which is where we are now. Market dislocations create investment opportunities that we look to capture but unfortunately, those are few and far between today. Despite our cautiousness, we maintain a long-term strategic weight to equities which has served our us and clients well over time.

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Royce Medlin
Chief Investment Officer