Share price development part 2: Is so much growth to be expected?

With a current price/earnings ratio of 22, US equities are neither particularly cheap nor particularly expensive when viewed in a historical context. In order to answer the question of a fair valuation more specifically, an expectation must be formulated with regard to earnings development. A high P/E ratio can be justified if earnings growth is sufficiently high; conversely, a low P/E ratio is not necessarily a buy signal.

This relationship is expressed by the so-called PEG ratio (price/earnings-to-growth ratio), which relates the valuation to earnings growth. As stated in our blog of 26 July 2023, the valuation for US stocks measured by the PEG ratio has increased from 17 to 22 in the last nine months – since the market low in October 2022. But has the earnings outlook also improved enough to justify this expansion in valuation?

To forecast the development of earnings, a leading indicator can be used in the form of producer confidence, for example. This indicator shows – based on surveys of companies – how the future economic environment is assessed. A negative change means that companies’ expectations of their future business activity have become gloomier. It can be assumed that the change in this indicator should be reflected in a change in profits over time.

 

 

In fact, this correlation is evident: A deterioration in producer confidence (measured by the Purchasing Managers’ Index, PMI) is reflected in lower profits with a lag of around twelve months. Conversely, a brightening of expectations leads to an improvement in profits with a lag.

Producer confidence has already been deteriorating continuously since December 2021. Profit growth is also declining steadily and stood at 4% at the end of June. If earnings growth continues to follow the trend in producer confidence, negative earnings growth rates can even be expected – in blatant contradiction to the recent increase in price/earnings ratios. The widening of the valuation cannot therefore be explained by an improvement in the earnings outlook. The risk of an overvaluation of equities has clearly increased…