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While the broad market is essentially unchanged in 2015, the market’s valuation is moving higher. That’s because earnings estimates for the Energy sector are falling quickly. And that has some concerned that the broad market must pull back to re-establish equilibrium.
At the end of 2014 the S&P 500’s forward P/E stood at 16.1. Today, it is closer to 16.5 (we’ll tally updated earnings estimates again at the end of this week). That forward P/E means the market is trading at a premium to its 5-year, 10-year and 15-year averages, according to FactSet.
At first blush this seems concerning for stocks in general. However, when we dive deeper it becomes apparent that the Energy sector is the major culprit of the earnings gap.
Just a month ago analysts expected the Energy sector to deliver EPS of $35.35 in 2015. But with the crash in oil prices, EPS estimates for the sector have been slashed by over 27%. Analysts now see Energy delivering EPS of just $25.69 in 2015.
Interestingly, analysts still see record-level earnings power for other sectors of the S&P 500 in the last three quarters of 2015. The current full-year expectation of 5.9% growth isn’t as rosy as the 8.2% figure from a month ago, but it’s still respectable, given that it factors in a 37.5% decline in Energy sector earnings.
All of this analysis shows that it’s important to look beyond the headline numbers to understand what is really going on in the market. A high-level figure, like a historically high forward P/E, can only tell part of an ever-evolving story.
And we’ll have much more data to consider in the coming weeks. This week alone major earnings announcements, including those from bellwether stocks such as Apple (NYSE:AAPL), 3M Co. (NYSE:MMM) and Google (NASDAQ:GOOGL), are almost certain to have analysts changing their forward estimates.
The chart below, courtesy of FactSet, shows 2015 current earnings forecasts for all sectors of the S&P 500, both at the end of 2014 (grey bars) and for today (blue bars). As you can see, all sectors except for Energy are expected to grow, with Consumer Discretionary, Financials, Materials and Health Care all leading the charge.
This suggests to me that, broadly speaking, the market is relatively healthy even if valuations appear stretched. And when we take a look at current expectations for earnings growth in 2016 (chart from FactSet below), the picture looks even better (note the projected rebound in Energy sector earnings).
I don’t like to see that the broad market is trading at a premium to its historical average. A forward P/E well above 16.0 suggests that stocks have run too far, something that has been a major concern for all investors given the market’s advance after the Great Recession.
But the bottom line is that I continue to hear good news from many of the companies that I follow closely (and many that I don’t). It’s still possible to find companies of all market capitalizations that have the potential to significantly outgrow the market in 2015.
This is why I continue to recommend stocks that offer attractive risk vs. reward profiles based on specific catalysts, dividend growth, stock buybacks and/or attractive valuations. Because even though the broad market appears to be getting expensive on a forward P/E basis, once you peel back the cover there is a lot to like in this “overvalued” market.
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