Corporate Earnings Versus Price-to-Earnings Expansion

May 16, 2016

Corporate Earnings Versus Price-to-Earnings Expansion Photo

I have been asked many times recently when equity prices will move and in which direction. The equity markets continue to trade sideways in a relatively tight range. My belief is that this is occurring for three main reasons. First, due to a low return world (global risk-free rates remain very low) as a result of significant central bank involvement in the global economy. The base line expectation should be for lower returns on high-risk assets like equities. Second, corporate earnings have struggled to move higher as the benefits of cost cutting and debt-financed share buybacks can only offset sluggish top-line revenue growth for so long. I believe that the marginal impact of these two tools being utilized by CFOs to enhance earnings per share is declining. Thirdly, price-to-earnings (P/E) ratios have improved significantly since the financial crisis and now look only slightly cheap on a historic basis.

In today's market condition, it is left to P/E expansion to push stocks higher, and given the concerns around the impact of the first two factors, stocks are stuck in a tight trading range. Until we see more pro-business fiscal policies and reduced regulatory burden on companies that support business investment, my base-case expectation is for stocks to post only modest positive returns for the foreseeable future. In this environment, stocks with solid and growing dividends and pro-shareholder buybacks are more attractive.

Tags: Monday Morning O'Malley | Stocks | Share buybacks | Price/Earnings ratio | corporate earnings

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