By Mike Boyle, CFA, Executive VP, Asset Management – May 30, 2017 Advisors Asset Management, Inc. (AAM)
We believe it goes without saying that the current economic recovery and accompanying bull market run for equities have been little appreciated and much maligned. Unfortunately, once again we are seeing an uptick in headlines and media coverage highlighting these topics. These include concerns about floundering U.S. GDP growth, a flattening yield curve, a sell-off in commodities, flattening home and vehicle sales, thin equity market breadth and stretched equity valuations as signs the bull market in equities is approaching an end. Throw in a multitude of geopolitical concerns as well as mayhem in Washington and it is pretty tough to comprehend why once again the S&P 500 just hit another all-time high. Well, tough to comprehend until we recall that magic elixir for equities – earnings.
For obvious reasons corporate earnings tends to dominate our discussions. About 10 months ago we detailed how we felt the earnings recession was coming to an end and that the equity markets were being driven higher by the prospect of a bottoming in earnings and an outlook for not only growth of, but acceleration of, corporate earnings. Sure enough this is coming to fruition and despite an array of naysayers taking the equity markets with it. We are now about 93.6% of the way through 1st quarter earnings season for the S&P 500 constituents and 77.3% are running ahead of expectations which is well above the long-term average of 73.0%. On a market-cap weighted basis earnings have grown 14.5% year-over-year which is the best level in over five years. There has been a lot of talk of the largest stocks in the index causing an upward bias and that is occurring but if we look at median earnings growth for the index we still have 10% growth which is still very solid and the highest level in over two years and has increased for five consecutive quarters.
Despite these very impressive earnings gains U.S. equity valuations are a bit stretched as price appreciation has outpaced earnings gains. Currently the S&P 500 sits at a price-to-earnings ratio (P/E) of 21.4 compared to a 5-year average of 17.8, a 10-year average of 17.2 and a 20-year average of 19.5. Based on the 20-year average we could argue U.S. equities are about 10% overvalued. However, as earnings are expected to grow 19.5% year-over-year we think diversified equity investors can realistically expect high single-digit returns over the next 12 to 15 months if valuations revert to their 20-year average and earnings pan out as predicted.
At the beginning of the year we voiced our fondness for growth over value and so far that has played out all three capitalization levels (large, mid and small-cap) with the biggest outperformance coming at large-cap where the S&P 500 Growth Index is outperforming the S&P 500 Value Index by 10.38% year-to-date (13.64% compared to 3.26% for 12/30/2016 – 5/25/2017). At inception of the style, indices stocks were uniquely classified as either growth or value by their price-to-book (P/B) ratios and then that evolved to include other factors such as P/E. However, year-to-date it seems dividend yield would be a good proxy. If we split the S&P 500 into five quintiles based on dividend yield we see the quintile with the lowest dividend yields have an average return of 10.15% (12/30/2016 – 5/25/2017) and the quintile with the highest dividend yields have an average return of 1.82%. Earnings and growth may be in the driver’s seat, but we believe value is in the passenger seat looking to take over at the next rest stop.
For more information contact your AAM Advisory Consultant at (888) 969-2663.
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Advisors Asset Management, Inc. (AAM) is a SEC registered investment advisor and member FINRA/SIPC.