The S&P 500 hit a new all-time high on July 26, lifting gains for the year to 20.7%, the best performance for the first seven months in 22 years, and within a whisker of beating that 1997 record of 21.5%. That breakout is wonderful for folks who showed the grit to stay invested during the big downdraft late last year. But the explosion in prices has made a longstanding problem worse: High prices today mean puny gains tomorrow.
From these levels, what returns can investors reasonably expect?
The price-to-earnings ratio for the S&P 500, based on the last four quarters of net earnings, now sits at 22.5, up from 18.9 at the close of the fourth quarter. That multiple stands well above the average of 19 for the last two decades, not to mention the reading of around 16 over the past century. Multiple expansion as a source of gains seems tapped out. The market’s P/E has been stuck in the low-20s, except for the brief drop in late 2018, for the past four years.
What’s driven prices skyward is an historic explosion in earnings. S&P 500 earnings-per-share have jumped 47% from mid-2015 to Q2 of this year, to a record of $134.39 in Q1. Don’t count on earnings growth to provide much more fuel. Profits appear in a near-bubble. They account for 9.5% of national income, versus the long-term average of 7.5%, and operating margins are running 9.41%, one-quarter higher than when the economy regained its mojo in mid-2016.
Profits are already slowing. The latest survey of analysts by research firm Factset forecasts a year-over-year decline in Q2 of 1.5%, following a flat first quarter. So given their already gargantuan size, and the current downward drift, don’t count on big profit gains to propel share prices.
Since markets are hitting the wall on both multiple expansion and profit growth, the best hope is that P/Es remain where they are, and profits advance at a far more moderate pace than the fantastic gains since 2015.
Bear with us: A crucial number is the current earnings yield. That’s the ratio of the earnings a company generates each year to its market value—in other words, the dollars in profits investors are getting for each dollar they pay. (The earnings yield—earnings divided by price—is the inverse of the P/E, price over earnings.) At today’s 22.5 P/E, the current earnings yield is around 4.5%, plus inflation that’s running at 1.5%, for a total of roughly 6%. If the market multiple stays where it is at 22.5, future returns––in the form of dividends, buybacks and capital gains––will total 6%. That’s the market math.