We have seen many high quality businesses suffer significant share price declines in recent weeks and months. For example, Netflix shares are down 68% from their 2021 high while Meta Platforms (Facebook) is 51% off its all-time 2021 high and Hargreaves Lansdown has seen its share price decline 60% from its 2019 high. And each case highlights that paying sky-high price-to-earnings ratios is fraught with (valuation) risk. For example, Netflix investors were paying 63 times expected 2021 earnings for the shares in 2021. In Meta’s case, investors were paying 29 times expected 2021 earnings and for Hargreaves Lansdown investors were paying 37 times expected 2019 earnings.
Each has stumbled in terms of delivering on investors’ ‘growth expectations’. Extrapolating strong growth into the distant future is an extraordinarily hard task, and paying high prices for such future growth always carries significant risk. A company that can ‘reliably’ grow its earnings at an above-average pace over a long period of time is a jewel for investors, but the reality is is that few companies can do so.
The same goes for the whole market. Over the 73-year period from 1949 to 2022, earnings for the S&P 500 Index have grown at 6.4% compound per annum. However, earnings growth from the end of 2019 to the end of 2022 is expected to be 14.3% compound per annum. The starting base in late 2019 is also not a depressed one so that a 14.3% growth rate off a robust base indicates it is well above what can be sustained in the long-term as evidenced from the growth rate from 1949.
In our view, S&P 500 earnings have been boosted by massive US fiscal deficits. In an environment where US interest rates are rising and where US Government debt is at historically high levels it will prove exceptionally difficult to sustain such fiscal deficits. In other words, we suspect S&P 500 earnings will revert to the long-term mean at some stage.
If we use trend earnings growth (i.e. 6.4% per annum) rather than current expectations which equates to $168 per share, the S&P 500 Index is currently trading on 25 times 2022 potential earnings, 56% above the long-term average valuation of 16 times earnings. However, as we have seen with Netflix, Facebook and Hargreaves Lansdown, if earnings decline or do not meet expectations, the price investors pay for those lower earnings also declines.
So, if S&P 500 earnings revert to the mean and are below investors’ expectations, investors will likely also pay a lower price for these earnings. If we take, say, 20 times (still above the long-term average) 2022 potential earnings, this would give us an index price that is 23% below today’s level.
The achilles heel of the market is that investors routinely pay a high valuation (price) for high earnings and a low valuation (price) for low earnings. The reason is not new. Investors are very emotional and get over enthusiastic at the top and depressed at the bottom. Quite simply, investor behaviour amplifies the swings in earnings that naturally occur with the business cycle. Therein lies an explanation for why the markets are so volatile. The markets are us, and we are emotional!