Remember the American television soap opera, “As the World Turns”? Investing can be just as, if not more, dramatic at times.

Indeed, after six consecutive quarters of declines, S&P 500 trailing four-quarter operating earnings per share (EPS) increased by 6% year-over-year to $106 in the fourth quarter of 2016, and by another 13% year-over-year to $111 in the first quarter of 2017.

Looking ahead, operating EPS are forecast to increase by 20% year-over-year to $128 in the fourth quarter of 2017. That means investors should expect the S&P 500 to rise 20% this year, right? Not necessarily.

The level of the equity market is equal to the product of the following two factors: 1) EPS; and 2) the price-to-earnings (P/E) multiple. As such, it’s important to understand how earnings and multiples behave and interact over time, and how U.S. equity returns typically fare when earnings are rising and multiples are compressing, as they’ve been doing for almost a year.

The Tug-of-War between Earnings and Multiples

In Exhibit 1, we present the S&P 500 trailing 12-month as reported P/E alongside S&P 500 trailing 12-month as reported EPS (on a natural logarithmic scale) since 1971. Shaded areas denote P/E expansion regimes (from trough to peak), while white areas indicate P/E contraction regimes (from peak to trough), which is where we are now.

S&P 500 Earnings

Some readers may be surprised to observe that year-over-year changes in the two variables have had a strong, inverse correlation coefficient of -0.83 over the last several decades. In other words, when earnings are rising, multiples are often falling; the opposite is also true.

Why? Stock prices are real-time, financial-market variables that anticipate the twists and turns of the business cycle and corporate profits further down the road. For example, near economic recessions – which mark the end of the last business cycle and beginning of the next – stocks (P) generally bottom before earnings (E) because the broad investment community is looking across the valley to better times ahead, thereby driving the P/E ratio higher.

Rising Earnings Rarely Overcome Compressing Multiples

Historically, U.S. equity returns have been significantly above average when the P/E ratio was expanding and earnings were falling. Since 1974, the S&P 500’s median compound annual growth rate (CAGR) during P/E expansion regimes is 28%. Compare that with a CAGR of 7% over the full sample period.

In our view, however, we aren’t in a P/E expansion regime; we appear to be in a P/E contraction regime. As noted above, earnings have been rising and multiples have been compressing for about one year. Since 1971, the S&P 500’s median CAGR during such periods is -6%.

Our View: International Stocks Should Keep Beating U.S. Stocks

Granted, the relationship between changes in the P/E ratio and EPS isn’t perfectly inverse (i.e., the correlation coefficient isn’t -1), meaning there are exceptions. For example, it’s possible for earnings and multiples to rise together.

However, the U.S. economic expansion appears to be in a later stage and the Federal Reserve is gradually raising short-term interest rates, as well as formulating a plan to normalize its balance sheet – all of which are headwinds to the P/E ratio.

To be clear, we don’t believe the operating environment has become so hostile for U.S. equities that investors should be selling aggressively. Rather, we simply think the atmosphere has become less friendly for U.S. stocks and investors should expect modest gains going forward.

For these reasons, we continue to advocate underweight positions in U.S. equities and overweight positions in international equity markets with more attractive valuations, economies that are in relatively earlier stages of expansion, and accommodative central banks.

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