N/A | Oct 02, 2023

I recall a television advertisement years ago featuring legendary investor Peter Lynch. Lynch helped popularize the “growth at a reasonable price” (GARP) strategy that Provident largely follows today, registering a sterling track record as the manager of the Magellan Fund at Fidelity between 1977-1990. This advertisement probably aired toward the end of his tenure with the Magellan Fund. In it he emphasized the link between earnings growth and market performance, saying something along the lines of “earnings drive the market.” As an impressionable youth with an interest in the investment business, this message stuck with me. It is something I think most investors generally understand, but the breakdown in short-term correlation between earnings growth and market performance sometimes obscures the tie between the two.

For example, look at what has happened in markets over the past year and a half. In 2022, earnings for the S&P 500 grew 5%, while the market fell 18%. The story in 2023 has been just the opposite, as earnings for the S&P 500 through the second quarter were down while the market advanced nearly 16%. This is not how celebrated market wizard Peter Lynch told us things work! I’m being facetious because what Lynch implied in the advertisement was that while the link between earnings and the market can be tenuous over any shorter period, it generally holds over the longer-term.

The level of the S&P 500 can be broken down into two components: the earnings for the S&P 500 and a market P/E multiple. According to FactSet’s Earnings Insight, projected earnings for the S&P 500 for the current year are $222, which when combined with a P/E multiple of 20x results in the S&P 500’s current level of approximately 4,500. It is the change in P/E multiple that drives the deviation between earnings growth and overall market returns. Multiples can change for a variety of complex reasons, but they generally reflect investor sentiment, expanding as investors’ read of the overall environment improves. As sentiment sours, multiples contract.

In the context of the past year this makes sense. Multiples contracted in 2022 as inflation became a greater concern and the Federal Reserve embarked on a rate hike campaign, lifting rates to a 22-year high. Investors’ concern was that the aggressive actions taken by the Fed to curb inflation would ultimately slow the economy, resulting in a recession. However, in 2023 the resilience of the economy combined with a reduction in inflation increased hopes of a soft landing, resulting in multiple expansion. Furthermore, earnings growth is expected to return in the third quarter and consensus forecasts reflect a 12% advance in earnings in 2024, up from 1% expected growth this year. So, with the improved sentiment, where are we today from a price-to-earnings multiple perspective? According to FactSet, on a forward 12-month basis, the current P/E ratio for the S&P 500 is 18.8x, about in line with the five-year average and modestly above the 10-year average of 17.5x.

With the past couple of years as an example, it is clear changes in multiples can meaningfully impact returns. However, history suggests that longer-term market returns are more closely correlated with earnings growth. The following table is based on information provided by Aswath Damodaran, a professor of finance at the Stern School of Business at NYU. It lists annualized growth for both the level of the S&P 500 and earnings across various timeframes ending in 2022. The difference between the two can be attributed to the overall contribution from the change in multiples.

Annualized growth rates through 2022