Stock prices have been rising faster than earnings are expected to grow.
As a result, valuations have been getting richer with the price-to-expected-earnings ratio reaching 16.6, the highest level since March 2005.
Recently, the disconnect between stock prices and earnings expectations have been more about falling earnings expectations than surging stock prices (see chart below).
“At the sector level, the Energy sector has witnessed the largest decrease in the forward 12-month EPS estimate of all ten sectors during this time frame,” FactSet’s John Butters noted. “Since December 31, the forward 12-month EPS estimate for the Energy sector has dropped by 27.3%. No other sector has recorded a decline in the forward 12- month EPS of more than 1.6% over this period.”
This of course is due to plunging oil prices.
Butters notes that the price-to-expected-earnings ratio for energy sector stocks is currently at its highest level since April 2002.
“It is interesting to note that despite the decline in the forward 12-month EPS estimate for the S&P 500 (due to the downward revisions to EPS estimates in the Energy sector) over the past few weeks, analysts are still projecting record-level EPS for the S&P 500 for three of the next four quarters,” Butters said. “At this time, the Q3 2014 quarter has the record for the highest bottom-up EPS at $US30.09. While industry analysts in aggregate predict that earnings for Q1 2015 ($US28.35) will be below this record-level EPS, they believe EPS for the S&P 500 will exceed $US30.09 in the following three quarters (Q2 2015 — Q4 2015).”
Keep in mind, just because valuations are above average doesn’t mean they will collapse immediately. Valuations tend to drift, which means the price-to-expected-earnings ratio may go much higher.