IndexFunds.com Staff

High Valuations are counting on Earnings Growth

Wall Street analysts predict substantial earnings improvement for US companies in the coming year, and investors have taken note. The stocks that command the highest Price/Earnings valuations (the most common measure for how "pricey" a stock is) are those picked by the pros to most improve their profits. This scenario will be helped by the fact that firms are bouncing back from a tough earnings year so comparisons will be easier going forward. But it will be hurt by an economy that has not shown definitive signs of takeoff. ETF investors should evaluate the prevailing optimistic assumption on future earnings, because current stock valuations appear to be counting on it.

The following chart shows just how bullish analysts are on earnings growth for major US equities sectors in the coming 12 months starting August 1, 2003:

Source: IBES

The total US stock market, (represented by Vangard's Total Market VIPER), is expected to grow earnings a healthy 79%. Only Dow Industrials ETFs are expected to have flat earnings. And the much maligned technology and telcom sectors are expected to show the biggest bounce.

These projections are compiled from financial analysts at brokerage firms, many of which also pitch investment banking business to the listed companies. Examples of analyst conflict of interest such as that of Jack Grubman at Citigroup (formerly Salomon Smith Barney) have been rampant in recent years, sparking widespread investor skepticism over the trustworthiness of their projections.

Not helping matters is that expectations of better earnings ahead appear priced into current stock levels. The following chart shows a close correlation between P/E ratio and expectation of earnings growth, such that investors are bidding up prices of stocks where analysts call for earnings growth:

Source: Merrill Lynch Equity Derivative Strategy

While not the only valuation measure for assessing the market, P/E ratios are perhaps the most widely used. The inverse of the P/E, or the earnings yield (E/P), is useful to consider what kind of implicit return investors would get without earnings growth. It does not take into account dividends. Nearly all ETFs are showing earnings yields of single digits, and some are hovering around risk-free Treasury yield rates. Clearly earnings had better improve, or investors are likely to flee to safety. The complete data follows:

Source: Merrill Lynch Equity Derivative Strategy