Financial Engineering Flashing Red for U.S. Equity Valuations

July 16, 2015

Financial Engineering Flashing Red for U.S. Equity Valuations Photo

Six years into one of the most unloved bull markets in U.S. equities, investors are still searching for signs that the positive run may be coming to an end. Looking at the price/earnings (P/E) ratio, the most commonly used relative value metric, current equity valuations look slightly expensive. However, adjusted for today's low interest rates, the S&P 500 P/E ratio of 19 – in comparison to its historical average of 16 – appears more in line with fair value.

A breakdown of how companies are creating the earnings component of the P/E ratio suggests a more cautious view for future equity market performance. Earnings per share (EPS) growth is increasingly dependent on financial engineering – the development of technical financial models to maximize profits – as opposed to organic sales growth or improved operating margins. The low interest rate environment and easy credit conditions have enabled companies to take advantage of debt financed share repurchase and mergers and acquisition activity to increase EPS.

The chart above highlights the growing impact financial engineering has had on EPS growth during the past four years. Without the benefit of financial engineering, EPS growth is projected to grow by less than 1% during 2015 according to Bridgewater Associates research.

Key takeaway: History suggests earnings growth and equity valuations can temporarily be supported by financial engineering but these benefits will inevitably subside as corporate borrowing costs increase. Investors should monitor the quality of corporate earnings to help assess the prospects for the sustainability of EPS growth as well as overall equity market performance.

Tags: Chart of the Week | P/E ratio | U.S. equities | financial engineering | corporate earnings | Equity market

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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