In a "shrinkflation" world, investors might want to stop and appreciate the stock market, which is giving them more for less.
American shoppers are struggling. They have to cope with the frustration of higher prices brought by inflation. They suffer the indignity of shrinkflation when they pay the same price for less product. And they must endure the humiliation of the particularly insidious "skimpflation, " when manufacturers stint on costly ingredients, such as the chocolate and peanut butter in a peanut butter cup, and replace them with fillers like "chocolate candy" and "peanut butter cream."
Against that backdrop, U.S. stocks stand out by offering investors more for less. While the S&P 500 index is up 22% in the past year, valuations have actually come down, with the forward proce/earnings ratio falling from 22.1 times forward earnings to 20 times, per Bloomberg data. It's as if Gushers got rid of the juicy filling and replaced it with 1982 Chateau Margaux.
So what's going on? Simply put, the "E" is rising faster than the "P." Second-quarter earnings season has been one for the ages, with 86% of companies beating earnings estimates, above the average of 78%, and S&P 500 companies growing earnings by a startling 50.4% from one year ago, per FactSet.
Careful scoffing that it's all just artificial intelligence. As Evercore ISI's Julian Emanuel points out, "2Q reports have reinforced the strength in Tech and Energy, but the bigger surprise has been how widely earnings strength has extended across and within sectors." Importantly, the good times are expected to last; analysts have an infamous tendency to cut earnings estimates for the coming quarter, but they've actually upped their expectations for Q3 earnings by 0.3%.
That earnings optimism might actually be a worry, says Megan Horneman, chief investment officer of Verdence Capital Advisors. "Yes, this earnings season has been mind-blowing," she explains. "But there's been no end in sight to the upgrades," suggesting "there's some complacency."
Others worry about the quality of the earnings themselves. As Barron's Randall Forsyth noted a few weeks ago, short seller Jim Chanos points out that the accounting treatment of AI spending may be flattering earnings, since equipment sellers log the revenue faster than the buyers recognize the expenses. This could partially explain why the P/E ratio for the tech sector has fallen more sharply than for the overall index. But again, the earnings growth has been broad, and even non-AI sectors like consumer staples have risen over the past year without boosting valuations.
To some, the earnings themselves are so far above trend that they distort short-term valuations. David Rosenberg of Rosenberg Research notes that Robert Shiller's CAPE multiple -- a measure that compares the current S&P 500 price to earnings from the past 10 years -- is at levels not seen since the dot-com bubble. But what the disparity between the forward P/E ratio and the CAPE ratio tells us is that companies are expected to make a heck of a lot more money in the next year than they've made in the past decade, raising the question: Should we really be concerned about the amount of money made in a pre-Billie Eilish world?
That's not to cast aside all doubts. AI spenders like Amazon.com and Alphabet are able to generate serious revenue from their cloud businesses, which is one reason for tech's 12% rally from the July lows, but that doesn't mean all their spending will pay off. And while the market rose a bit on the surprise loss of 23,000 jobs in July, given that it seems likely to forestall Federal Reserve interest-rate hikes, the hope is that the report doesn't indicate real cracks in the employment picture.
But the bottom line is that the stock market has resumed its upward trajectory this week after a two-month pause. The S&P 500 rose 3.4%, the Dow Jones Industrial Average advanced 2.8%, and the Nasdaq Composite gained 4.8%, with the S&P 500 and Dow set to break out to new highs. And given the strong fundamentals underpinning the gains, it's fair to say that the rally isn't built on sand.
Or peanut butter cream, for that matter.
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