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Price & Earnings: The Race to the Top

By Colin Twiggs
May 19th, 2017 3:30 a.m. EDT (5:30 p.m. AEST)

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Now that 93% of S&P 500 stocks have reported first quarter earnings we can look at price-earnings valuation with a fair degree of confidence. My favorite is what I call PEMax, which compares Price to Maximum Annual Earnings for current and past years. This removes distortions caused by periods when earnings fall faster than price, by focusing on earnings potential rather than necessarily the most recent earnings performance.

PE of Maximum Earnings

Valuations are still high, but PEMax has pulled back to 22.78 from 24.16 in the last quarter. Valuations remain at their highest over the last 100 years at any time other than during the Dotcom bubble. Even during the 1929 Wall Street crash (Black Friday) and Black Monday of October 1987, PEMax was below 20.

While that warns us to be cautious, as valuations are high, it does not warn of an imminent down-turn. Markets react more to earnings than to prices as the chart below illustrates.

S&P 500 Earnings per Share Growth

The last two market down-turns were both precipitated by falling earnings — the blue columns on the above chart — rather than valuations.

While it is concerning that prices have run ahead of EPS — as they did during the late 1990s — consolidation over the past quarter should allow earnings room to catch up.

Observation, experience, memory and mathematics these are what the successful trader must depend on. He must not only observe accurately but remember at all times what he has observed. He cannot bet on the unreasonable or on the unexpected, however strong his personal convictions may be about man's unreasonableness or however certain he may feel that the unexpected happens very frequently. He must bet always on probabilities that is, try to anticipate them....

~ Jesse Livermore

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Colin Twiggs is director of The Patient Investor Pty Ltd, an Authorised Representative (no. 1256439) of MoneySherpa Pty Limited which holds Australian Financial Services Licence No. 451289.

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