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When earnings growth is scarce, expect to pay dearly for it

Ten companies are generating 90 per cent of the S&P 500's earnings growth, highlighting the most important trend for investors today – earnings scarcity.

As the global economy slows down, the number of companies with positive earnings growth is shrinking. It's not a surprise, therefore, that in this environment, 10 mature large-cap companies – Western Digital, General Electric, Citigroup, IBM, JP Morgan, Wells Fargo, Goldman Sachs, AIG, Bank of America and Apple – account for 88 per cent of S&P 500 earnings growth in 2012 (according to Morgan Stanley Research).

It is a fact, albeit a counterintuitive one, that periods of slow growth are characterized by rising price-to-earnings ratios for the major equity benchmarks. How can this be? The smaller the number of companies capable of producing higher profits, the higher the price (in terms of valuations) the market will be willing to pay for them.

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The best way of illustrating the phenomenon is by comparing the relative performance of the equal-weighted S&P 500 index and the usual market cap weighted benchmark (see chart at left). In the equal-weighted index, the performance of small-cap stocks has the same effect on overall benchmark performance as giants like Apple and Exxon Mobil do. When the majority of companies' profits are growing, the jump in the stock prices of smaller companies sends the equal-weighted index well above the market cap-weighted benchmark.

The most recent period where market performance was concentrated in a limited number of companies occurred from 1997 to 2000, before the dot-com bust. As the chart illustrates, investor assets moved away from sectors where earnings were not growing – i.e. most of them – and moved to technology, media and telecom stocks, where outsized profit growth was apparent. The result was that outperformance of the market-cap-weighted S&P 500 and an average price earnings level for the S&P 500 that skyrocketed to 30 times by early 2000.

Multiple expansion is not yet visible in the S&P 500 but the drastically declining number of stocks driving earnings growth suggests that a similar process to the tech bubble is under way. As long as the global economic backdrop remains sluggish, positive equity performance should become concentrated in the few sectors where companies can generate profit growth. Price-to-earnings levels and stock prices for these companies will expand, likely dramatically, as more and more investors pile in.

The trend is just beginning, but eventually a market like this will be uncomfortable for many investors, particularly those inclined towards value strategies. Expensive stocks with high P/E multiples will outperform for far longer than most expect – though not, of course, forever.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More


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