Market rally: the earnings dimension

As the FTSE 100 moves into positive territory for the day, and after 19 successive 'up' Tuesdays for US markets, we will continue to ask whether this market rally has gone too far.

Economic headwinds persist

Today’s UK data, though only one element of a much larger picture, does reinforce the general perception that stock markets have got too far ahead of the real economy. Retail sales in the UK fell at their fastest pace for over a year during April, having been forecast to rise slightly. Meanwhile, Chinese growth (although strong by Western standards) is at a low ebb for the usually dynamic economy.

So, with economies sluggish, can stock markets look to sustain their gains? One way to examine it is to look back at earnings ratios, and from doing this I remain cautiously optimistic.

The chart below shows the S&P 500 (in blue) and the average price-earnings ratio (in red) from 1990 until today.

Trade FTSE 100 today

What we can see is that average earnings are not too high compared to the historical average. At present the S&P 500’s PE ratio is 16.3; still below the 33-year average of 19.7.

In fact, the earnings ratio has been steadily declining since its peak in the dot-com boom in 1999/2000, with a spike to 24 after the financial crisis at the end of 2009. If this was a bubble then we would, in my opinion, be seeing a PE ratio much higher than we’re seeing currently.

The PE ratio is not a foolproof metric. It has flaws: notably its vulnerability to inflation and the fact that earnings for individual companies can be manipulated. In addition, PE is a backward-looking measurement, not taking into account future developments.

Most indicators have their own flaws which may undermine any other assessment of the stock market; but from this data it cannot be argued that the market has become expensive. There seems to be plenty of upside in PE ratios, which at least suggests that this market rally has not run its course just yet.

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