The return of a stock, or the market as a whole, is the sum of growth in earnings per share, the dividend yield, and change in valuation. The change in valuation can either be a headwind, as investors reduce the multiple they are willing to pay for a stock’s future earnings, or it can be a tailwind, as they may increase the price they will pay for each dollar of earnings. Theoretically, an interest rate decline is supportive of price-earnings multiple expansion, as future earnings are discounted at lower rates revealing higher present values. This does not always hold, and can be dependent on the overall economic backdrop.
The 2018 earnings growth rate for the S&P 500 was over 20%, yet the market ended the year in the red. The reason? Multiples contracted. The contraction in multiples more than offset the growth in earnings for the year, and in fact, also offset the dividend, leaving investors with a total return of -4.75%. Conversely, this year we have seen a notable multiple expansion driven by the expectation of increasingly dovish Fed policy and in the face of flat earnings.
So here we sit, with valuations above historical ranges on arguably depressed earnings. The market is already pricing in several rate cuts, which leaves little if any room for further valuation expansion, and may in fact suggest a reversion toward the average. Logic would suggest that future equity returns will be more directly a function of earnings growth and dividend yield.