Saturday, August 17, 2013

S&P 500 Earnings Above Or Below Trend?

One market factor frequently mentioned regarding current S&P 500 earnings is they are far above historical trend. An example is from a recent article on the Zero Hedge website titled, Why Stock Prices Are More Stretched Than You Think: A Tale Of 3 P/E Multiples. A common discussion then leads to commentary that earnings will revert to their trend and in this discussion that means a decline in earnings. The earnings chart referenced in this commentary is the one below (updated 8/18/2013). As can be seen in the below chart earnings are above their long term [exponential] trend line. However, the below chart [is using an arithmetic scale on the y-axis] does not properly account for the percentage change in earnings. The Zero Hedge author's technical notes can be found here.
From The Blog of HORAN Capital Advisors

As can be seen in this next chart that displays earnings using a logarithmic scale, earnings are actually below their long term trend line. With a logarithmic scale [on the y-axis], the distance on the chart from $10 to $20 is the same as $100 to $200. The percentage move in both cases is the same and if one is looking at earnings growth, using a logarithmic scale is important.

From The Blog of HORAN Capital Advisors

Nearing the end of Q2 earnings reporting season, we would like to see a higher rate of growth in company earnings. However, Q2 earnings are expected to increase 4.7% for the quarter and this is higher than the 2.9% expected prior to the Q2 earnings season. Additionally, Thomson Reuters reports 67% of companies beat earnings expectations which is higher than the long term average of 63%. From a revenue perspective, 53% beat revenue expectations, below the 61% long term average, but higher than the 48% average over the past four quarters.

For investors then, when evaluating charts, pay attention to the scale being utilized in the chart graphic.


Unknown said...


This is an important issue, and your point about appropriate scales is well taken in general.

However, I noticed you struck out a sentence, which ties into my point. The scale being used isn't an issue with the illustration you critique. I am glad you recognized that, but your striking of the sentence without clarification makes it seems as if it is an issue still.

Of more concern to me is whether we are comparing apples to apples. The exponential earnings trendline used by the original author starts in 1950. Yours starts in 1985 when earnings were below the trend since 1950 and end now when earnings are above the trend since 1950. This leads to an upward bias in the data it appears to me.

In addition, the period you chose has been one dominated by a long period of exceptionally high profit margins, while revenues have been relatively normal for the period as a whole. This has led to a period where earnings growth was higher than typical. Unless that can be repeated (continuing growth in profit margins) then future growth should track more closely revenues. The trend you illustrate in that case would be more misleading still.

That assumes profit margins average what they have in recent years. If not, and they revert to past levels, then we should expect profit growth to not resemble the more recent trend you illustrate by a wide margin over the next 10-20 years. In fact, over the next 10 years we would expect little to no real growth were that to happen, which would track closely the trendline of the original author. Adding in the starting and end point issues of using a shorter period such as you use would lead to a wild overestimation of potential profit growth based on the trend you illustrate.

Finally, you don't say whether you are using as reported or operating earnings. While operating earnings have their uses, the two types of earnings have diverged more and more over time even if one regarded operating earnings as superior (I don't, but that is another discussion.) Over time as companies have changed their practices in how operating earnings have been used has resulted in a growing divergence between the two series which would result in another upward bias to the earnings trend you illustrate that would not be replicable in the future unless such a divergence would grow at a similar rate over time. Obviously if it were to shrink the implications would be starkly different. So, if you are using that series I would suggest that makes the issues with the specific period chosen even larger. For consistency in reporting over time reasons measuring trend growth with operating earnings is just plain problematic even if you feel they are a more useful than as reported earnings now and in the future for other purposes.

Anyway, those are the first few questions I would like to see addressed.

Many thanks,


David Templeton, CFA said...


Thanks for the questions/comment.

From a procedural perspective, when I alter content that has been posted for more than two hours, I strike through the original content and replace it with the current content. I don't believe it is editorially appropriate for me to change content without the reader knowing what content has been changed. In this case a chart was involved so I deleted the earlier chart. The author of the original zero hedge article requested I change some original verbiage which I agreed to do.

With respect to earnings. The chart is using forward 12 months earnings per share estimates and not operating earnings.