Earlier this week, the S&P 500 eclipsed its May 2015 peak and established a new high for this market cycle. Sentiment has turned decidedly more positive over the past few weeks as the Brexit decision turned out not to be the immediate catastrophe that some had feared, a strong jobs report for June put to rest fears raised by the weak job market in May, and Japanese voters endorsed Prime Minister Shinzo Abe’s attempts to reignite economic growth by giving his party a solid majority in last weekend’s elections.

We have no desire to rain on the celebratory parade of new market highs, but nevertheless remind our readers that sentiment drives price, whereas fundamentals drive value – and price and value are therefore different things. The value of the market remains challenged, and investors would be wise to pay attention to the following three trends, even as prices set new records.

The ultimate driver of value is earnings, and corporate profits are in recession. As the nearby chart illustrates, S&P 500 operating earnings have declined year over year in each of the past six quarters. The collapse in energy prices is partially to blame, but in the first quarter of this year, seven out of 10 sectors in the S&P 500 posted earnings declines. The pain is widespread. In an environment of modest economic activity and little inflation, it is difficult for businesses to increase unit volume sales or prices, and at this mature point in an economic cycle, most of the benefits of cost cutting and margin expansion are already reflected in companies’ bottom lines.


Over the next few weeks we’ll get an updated picture of these trends as companies report second-quarter earnings. Consensus expectations call for earnings to grow 7% year over year in the second quarter and then accelerate into the fall, but similar expectations for a rebound have been dashed in the past. While the headwinds of the fall in energy prices are increasingly distant, the recent strength of the dollar may sap some profitability from companies heavily reliant on foreign sales. Time will tell, but it is hard to imagine the market moving meaningfully higher unless earnings provide support.

To make matters more challenging, the combination of shrinking earnings and rising prices has pushed the valuation of the market well above its historical averages. The S&P 500 trades at almost 22 times trailing operating earnings, slightly more than one standard deviation above its long-run average of 15.4 times. Market valuations and interest rates are loosely inversely correlated. As interest rates fall, the discount rate applied to future earnings similarly falls, which boosts the present value of those future earnings. Record low interest rates should therefore lead to higher-than-normal valuations, offering some rationale for the nearby graph. Nevertheless, we worry that low interest rates reflect policy more than economic reality, and thus don’t derive much comfort from this historical correlation.


It is important to note that valuation is a poor timing tool. Expensive things can get more expensive, and cheap things can get cheaper. Lofty valuations don’t spell the end of a market cycle, but they do highlight the necessity of careful attention to valuation when buying individual stocks.

A third and final point of caution is that this week’s new market highs are being driven by a small handful of stocks. Even as the index establishes new records, just 44 of the companies within the 500-stock index (9%) have similarly posted record highs, whereas 114 companies (23%) remain 20% or more below their highs of the past year. As the S&P 500 is capitalization-weighted, larger companies have a bigger influence on the index level, and a relatively small number of companies are lifting the market higher. As the nearby graph illustrates, the apparent health of the overall index is not representative of most of its constituents.


The good news is that opportunities remain for disciplined value investors, even as the index level sets new highs. The bad news is that narrowly led markets tend to be more volatile, and the narrow breadth of leadership – combined with poor earnings growth and lofty valuations – lead us to conclude that market volatility will linger unless and until there is more support from earnings growth and broader market leadership.

We will watch the upcoming earnings season closely for evidence of a rebound in corporate profits and further support for equity prices.


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