Global Allocation Insight

Are investors ignoring strong earnings?

May 17, 2018

Companies continue to deliver, but the market does not
seem impressed.

Earning expectations have been unusually high, and many U.S. companies are actually delivering on them. But despite impressive first-quarter earnings reports, the S&P 500 Index has been sputtering year-to-date. This begs the question – why are investors ignoring strong earnings? The simple answer – they’re not. Instead, we believe this weak index performance is being driven more by stretched valuations and changing economic and financial market conditions.

Recent levels of the trailing price-to-earnings (P/E) ratio of the S&P 500 Index suggest that the amount investors are willing to pay for a dollar of earnings is declining. After peaking in late January at an eight-year high at prices nearly 23.5 times earnings, the P/E ratio on the index has fallen by over 10% to levels hovering around 20 today.

Earnings have continued to rise, but P/E ratios have begun to fall
Trailing price-to-equity (P/E) ratios and earnings per share (EPS) on the S&P 500 Index since 1995.

Earnings have continued to rise, but P/E ratios have begun to fall

Source: Bloomberg, May 2018.

Given a nearly decade-long equity rally, valuations have become stretched and therefore, it is not very surprising that investors seem to be reconsidering paying even more for a dollar of earnings. However, the reasons for declining P/E ratios in 2018 are nuanced. While the most obvious culprit is higher interest rates, U.S. equity multiples have been known to be driven by a broader array of financial market conditions. For investors today, it’s not simply that rates are going up. The dollar has been strengthening as well, which further tightens financial market conditions.

Apart from financial market conditions, equity multiples also tend to co-move with the real economy. Historically, a combination of strong growth and low inflation has been the best environment for multiples. While economic growth is still solid and inflation remains low, the first quarter of 2018 brought some deceleration in growth and a modest acceleration in inflation, posing an additional headwind for equity prices at a time when multiples are already elevated.

The BlackRock Global Allocation Fund holds an underweight in U.S. equities relative to the reference benchmark, although we have found attractive opportunities in software and technology services companies, within media, and among the chemical industries.

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Russ Koesterich
Portfolio Manager, Global Allocation
Russ Koesterich, CFA, JD, Managing Director and portfolio manager, is a member of the Global Allocation team within BlackRock's Multi-Asset Strategies ...
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