CPM Investing LLC - Research Publications
To better understand the impact of corporate earnings on how the stock market may react to resilience cycles, we evaluate various valuation ratios and their relationships to one another. The information below shows data as of October 2022, and focuses on our Peak-Earnings Indicator (PEI). This analysis influences our decisions to alter the aggressiveness of portfolios. Please see this page for a brief definition of valuation ratios.
By determining when current Price/Book (P/B) and Price/Sales (P/S) ratios of a stock index such as the Dow Jones Industrial Average (DJIA) diverge from its Price/Earnings (P/E) ratios, we can identify when investors, in general, believe that recent earnings are abnormally high and are likely to decline in the future. We have used this type of analysis since the mid-1980s and have found it helpful in identifying when companies within an index like the DJIA are likely to be at a peak in their earnings.
Let’s assume that normal behavior is for all three valuation ratios to move together – P/S, P/E, and P/B moving up and down together with stock price changes. However, when the P/E ratio drops faster than the P/B and P/S ratios, it could be inferred that the market is placing an unusually low value on the most recent earnings. Simply put, the market, in its wisdom, is implying that it believes current earnings are abnormally high and are likely to decline in the near future; it is not willing to pay a high price for them.
Figure 1 below shows when the P/B ratio stays high when the P/E ratio drops. This comparison uses the percentile ranks for each statistic. One can see that there are three periods (A, B, C, and D) when the P/E ratio (green line) moves lower than the P/B (blue line). These periods occur before the decline of 2020 (C) and the decline of 2008 (A).
We use this data to create a metric that indicates the market’s current assessment of recent earnings, which we call the Peak-Earnings Indicator (PEI).
Figure 2 below highlights the period when the P/E ratio dropped more abruptly than the other valuation (P/B, P/S) ratios. You can see the spikes in this indicator just before the major price declines, as represented by the price of the DJIA (log scale, brown line). The PEI spikes indicate that the market is expecting earnings to decline from their current levels. As earnings decline, stock prices will be under greater pressure to move down.
Figure 3 below shows the actual earnings (shown as “EBIT,” which means earnings before interest and taxes, on a log scale) of the companies in the DJIA. The important pattern to look out for is the actual earnings declining after the PEI spikes.
We can see that the spikes in the PEI are indeed followed by declines in actual earnings.
Having used this type of analysis for many years, seeing two spikes close together (C and D) is unusual. Major spikes are typically separated by several years.
The story of the recent years that fits Figure 3 is that the market was expecting a decline in earnings in late 2019 (A), and although earnings did decline at that time, stock prices moved higher in response to the injection of Covid-related stimulus into the economy. Valuation measures then moved higher and reached unusually high levels in 2021, and by the end of that year, valuation measures were signaling a high risk that earnings were again at a peak. In early 2022, the Peak-Earnings Indicator (PEI) remained high.
In addition, the natural cycles of resilience that drive the MRI indicated growing market vulnerability in late 2021. This meant that the key market dynamics were in place for a deep decline in 2022.
It is useful to discuss the decline of late 2015 and early 2016 (point B in Figure 3). During that period, the MRI indicated high market vulnerability because of the natural cycles - much like they are doing in mid-2022. Yet, the PEI indicated only slightly elevated peak-earnings risk, it was not as high as the current level or in the 2007 decline (A in Figure 3). The market declines in early 2016 were not as deep as the others indicated in the chart above.