The skyrocketing profitability of oil and mining companies makes earnings look better than the reality of the rest of the stock market, distorting Wall Street’s favorite valuation tool – the price-to-earnings ratio.
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Take out the energy sector, and the expected increase in earnings for S&P 500 companies this year drops from 8% to just over a single percent, according to Refinitiv’s IBES data. Take out the mining companies and other commodity players, and the rest of the market’s profits are expected to decline this year.
The same is true for valuations: theS&P 500 Priced at 18 times the expected earnings this year – not a bargain price but certainly cheaper than 22 times, the norm level at the beginning of the year.
But excluding energy and commodity stocks, the valuation jumps back to 20 times this year’s expected earnings per share, according to Citigroup data – giving even less hope to those looking for cheap US stocks.
What’s surprising is that such a small sector — energy accounted for just 2.7% of the estimated S&P at the start of the year, and other commodity stocks even less — is making such a big impact.
There are two reasons for this. The first is simple: rising oil prices pushed the energy sector to 4.8% of the index in value terms, making it more influential. The second reason is more interesting, and gets to the heart of the question of how to treat valuations: oil stocks are the cheapest part in terms of price to expected profit ratio.
This means that the profits of the energy sector constitute a much larger share of the profits of the S&P 500 – more than a tenth – in relation to the weight of the sector in the index.
And when I say cheap, I mean it. The energy sector trades only 8 times the expected profits in the next 12 months, while the shares of the Marathon oil company are only 6 times. These are valuations that are usually given to dying companies, not those showing record profits.
By comparison, Amazon trades at 80x and Tesla at 56x, the kind of wildly inflated valuations that can only be justified by spectacular growth prospects.
Estimates opposite to those of Amazon and Tesla
But the valuations of the oil sector make perfect sense, because they are almost the opposite of Amazon and Tesla: profits are now at an all-time high, but are expected to decline in the coming years as high oil prices decline.
The price of futures contracts on the benchmark product, WTI oil, decreases as their maturity date moves away, from $86 for the closest contract to stabilizing at $57 by 2030.
Record oil profits are welcomed by shareholders, but because few think they will stay that way for long, investors give them only low multiples.
Such quirks remind investors that valuation tools are only tools, not a perfect guide to future returns. Oil stocks may look cheap based on the price-to-earnings ratio, but that’s only because that ratio looks a year ahead, for what will almost certainly be only temporarily high earnings.
Looking further, the price-to-earnings ratio is less attractive.
This is a reversal of what happened in 2020, when the bad oil prices (negative for a certain period) indicated that the sector was trading at very high multiples on earnings – which were then very low, which did not indicate then that oil stocks were expensive.
There are always certain companies in such a situation, but at the index level it usually balances out. Now it’s out of balance, because the oil sector makes so much money that it can significantly change the valuation of the entire S&P 500 index.
This year’s drop in non-commodity earnings estimates shows that little welcome reality entered analysts’ thinking over the summer, when forecasts were trimmed. My concern is that it is not enough, because next year’s revenue expectations remain high.
The bulk of this year’s cuts in earnings forecasts came in May. Since then, forecasts for growth in non-energy sectors have been cut from 5% to 1%. But analysts continue to hope that everything will be fine next year, penciling in a 10% growth, not far from the growth for 2023 observed at the beginning of this year.
This is how the Fed’s measures will affect earnings
If there is a soft landing in the economy, inflation falls quickly and the Federal Reserve starts cutting interest rates, a new period of economic expansion may begin next year and profits will grow.
What is more likely is that the economy will at least flirt with recession and profits will decline, and there will be a reasonable possibility that profits will take a hit from a significant downturn in the economy.
If my fears turn out to be well-founded and earnings turn out to be lower than expected, it means that US stocks are more expensive than they look.
In any case, if you want to learn about future returns, the price-to-earnings ratio is even less useful now than usual.