(By Michael Vodicka) One of the brightest spots of the economic recovery in the last few years has been earnings. Since bottoming out in early 2009, corporate earnings have been on a steady trend higher, with the S&P 500 recently moving back to peak earnings from 2007. That strong upward trajectory has gone a long way to fuel the stock market, with the averages currently trading just below recent multi-year highs.
But with more trouble brewing in Europe and China showing signs of a meaningful slow down, analysts and companies alike have taken a decidedly defensive tone going into Q2 earnings season, and we have seen that showing up in estimates over the last few months and weeks.
Total S&P 500 Earnings
As of June 29, the last trading day of the quarter, 94 companies had issued negative guidance, almost three times the 26 that issued positive guidance during the quarter and the most since 2001. Just last week, Ford Motor Co. (F) said it expects its Q2 loss to be triple its first-quarter loss as weakness in Europe saps global demand. Proctor & Gamble (PG) also fueled the bearish tone, lowering guidance for the second time in two months on weakness in both Europe and China.
Those downward revisions echo a larger theme of lowered earnings expectations from the analyst community going into Q2 earnings season. As it stands, analysts are projecting the S&P 500 to notch a 3% gain from last year, well below expectations of 6% earnings growth from April. But even though that would still represent positive earnings growth, a closer look at the individual sectors reveals more signs of weakness.
Leaders and Laggards
The financial sector alone is projected to account for most of that earnings growth, with total sector earnings expected to be up 42% from last year as the industry benefits from low comps and fewer loan losses. Stripping out financials would have a sharp impact, pushing total earnings growth into negative territory. Energy and materials are also projected to be weak, each sector suffering from slumping commodity prices on concerns about China and global growth. Even tech, which has been a big engine of earnings growth in the last two years, is showing serious signs of slowing down, with growth expected to decline to 2%, a sharp decrease from 14% last quarter.
When you add it all together, the S&P 500 is projected to earn just shy of $25 on the quarter and close to $100 on the year. But even though global economic and earnings growth is slowing, the valuation of the index at these levels is compelling.
With a forward P/E ratio of just 12X, the S&P 500 is trading safely below its 10-year median of 16X. And the last time the S&P 500 saw full-year earning approach $100, the index was trading above 1,552, a sharp 14% premium from current levels. Applying the median forward P/E over the last ten years of 16X on the S&P 500 places the index above 1,600, a sharp 17% premium to current levels.
The Take Away
Robust earnings growth has been a huge driver of stock prices in the last three years, with the S&P 500 projected to return to peak earnings from 2007 this year. But with headwinds in Europe and China weighing on growth and causing uncertainty, we are beginning to see the pace of earnings growth slow from cycle peaks coming out of the recession from 2009. But in spite of those headwinds, the valuation picture looks quite compelling, with the S&P 500 trading with a forward P/E below its 10-year median. Applying the median forward P/E of the last ten years implies more upside as we move into the back half of the year.