The S&P 500’s current P/E is 21.5 and its Shiller P/E or CAPE (cyclically adjusted P/E) is 24.66. Both numbers are well above their respective historical averages and widely cited, in particular the Shiller PE, as proof the S&P 500 is overvalued. Even the forward-looking forward P/E of the S&P 500 is above average. It’s currently 15.7 versus a 10-year average of 14.2. Earnings are also going the wrong way. With 96% of companies reporting so far, earnings have declined 3.3% this quarter. You have above average valuations and falling profits.
By pretty much any measure the stock market looks overvalued, so that should be the end of this article, right? Well, I’m not so sure. As with most things the devil is in the details, and I think that when you look under the hood, the S&P 500 might not look so overvalued after all. In particular I want to focus on how the commodities crash and foreign exchange rates have affected the numbers.
The commodity price crash
The commodity crash, in particular the drop in the price of oil, has had a large affect on the S&P 500’s reported earnings. As of this writing, energy and materials companies make up 6.6% and 2.8% of the weight of the S&P 500. As you can see in the graphic below from FactSet, it’s these two sectors that account for the bulk of the decline in earnings for the S&P 500.
While those two sectors don’t make up a large portion of the S&P 500 the sheer magnitude of the drop in earnings (driven in part by accounting write-down’s of assets, more on that later) is enough to drag down the entire index. In fact, if you excluded the energy sector, earnings would have risen 2.6% rather than falling 3.3%.
The other important thing to remember is that some of the decline in reported earnings for the energy sector is due to the write down of the book value of assets and not a reduction in cash earnings. Although make no mistake there is quite a large reduction in earnings as well! I was unable to find exact data on the breakdown of how much of the reported drop in profits was due to write downs.
I did take a look at several major energy companies and found accounting write downs accounted for around 25% to 50% of the drop in earnings. According to CFO Magazine, the energy sector wrote down $5.8 billion in assets in 2014 and was expected to write down a total of at least $50 billion in 2015. In addition, that’s from November 2015 when oil was up in the mid $40 per barrel range.
It’s these non cash accounting charges that are causing a large portion of the reported drop in earnings and thus depressing the “E” part of the S&P 500’s reported P/E ratio.
Foreign exchange impact
The other big item weighing on corporate earnings is the strength of the dollar. While the U.S. economy does not depend heavily on overseas demand, exports make up about 12% of GDP, the story is different for the S&P 500. Multinational companies that derive a substantial portion of their profits from overseas heavily dominate the S&P 500. About 40% of the profits for the S&P 500 are earned overseas. This means the S&P 500 is far more sensitive to a strong dollar than the economy as a whole. Over the past year and a half, the trade weighted U.S. dollar index has risen by almost 30%. As a result the strength of the dollar has contributed mightily to the lackluster earnings results of the S&P 500.
The graph below shows the trade weighted dollar with my annotation showing the current point that corporate results are comping their quarterly year over year results with.
As you can see we are about halfway through the rise of the dollar. After the next two to three quarters, if the dollar stays stable, companies will begin reporting results against the higher 120 to 130 value dollar rather than the weaker 100 value dollar of several years ago.
The underlying constant currency sales and profit growth for many companies is modest, but when translated back into dollars, it shows a decline. This means that the business is healthy and end demand is still there, and over the long run that is what counts. As with the commodity crash and the accounting charges, there is again an outside factor making corporate profits appear weaker than the underlying business.
Summary
So, after taking into account the affects of the asset write downs of the energy sector and the strength of the U.S. dollar, is the S&P 500 overvalued? Well, the answer is it depends.
The asset writedowns are a non issue and simply reflect an accounting decision, not actual cash flow. On the subject of actual cash flow the net effect of the drop in commodities prices is largely just to shift profits from one pocket to another. ExxonMobil (XOM, Financial) and Alcoa (AA, Financial) earn less because oil and aluminum prices have fallen while Delta Airlines (DAL, Financial) (fuel) and Coca-Cola (aluminum cans) (KO, Financial) earn more as their expenses drop. The profit shift takes time of course, so it will likely take a few more quarters to see the shift happen.
The effect of the strength of the dollar is a bit more concerning. Right now the markets seem to be pricing in a stop or at least a slow down to the strengthening of the dollar. This seems reasonable given the recent strength in the dollar seemed to correspond with the expectation of the Fed raising rates (which they did). Given Janet Yellen’s recent comments about the strength of the dollar being a concern, I think it’s not unreasonable to expect the dollar rally to at least weaken if not stop, as the Fed has signaled they do not want the dollar to further strengthen.
With oil prices seemingly stabilized at $25 to $35 per barrel at the lowest, analysts are estimating earnings for the S&P 500 will decline by 7.4% in the first quarter of 2016 followed by a 1.6% drop in the second quarter. By the third quarter, earnings are expected to start growing with a 4.7% rise followed by a 9.4% gain for the final quarter of 2016. It’s no surprise that the last half of 2016 is expected to show substantial earnings increases because those are the two quarters where company earnings will be comping against a relatively flat dollar.
In the end, whether or not the S&P 500 is overvalued depends on your estimates of what the dollar will do. If you think the dollar will stay relatively flat or stable, then the S&P 500 is likely fairly valued. If you think we are in for more dollar gains, then the S&P 500 might be overvalued.
Luckily, investors can simply punt on this whole issue and simply buy the stocks of companies that get most of their income domestically. Domestic focused restaurant chains such as Darden Restaurants (DRI, Financial) (we own), homebuilders, many retailers, utilities companies, health insurers, defense contractors (we own LMT, RTN, GD, and NOC), and tobacco companies like Reynolds American (RAI, Financial) and Altria (MO, Financial) (we own both). Additionally, many small and mid cap companies are also more domestically focused than their larger S&P 500 brethren.
