The Stock Market Grasps an Issue with Earnings Integrity – a Matter Demanding Attention Without Delay
Since 2023 has rolled along, Wall Street's major stock indexes have been on a nearly unstoppable streak. The ageless Dow Jones Industrial Average, the benchmark S&P 500 (SNP:SPY 1.59%), and the growth-powered Nasdaq Composite have reached numerous record-closing highs.
Investors have had no shortage of catalysts to keep the rally going. Artificial intelligence (AI), Donald Trump's election night victory, and strong corporate earnings are just a few of the factors contributing to this more than two-year rally.
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But with the stock market sporting one of its priciest valuations in 154 years, it's essential that companies execute flawlessly to maintain this rally. Unfortunately, some of Wall Street's most significant companies have an earnings quality issue, and it can no longer be ignored.
Donald Trump's election night victory (all three stock indexes soared during his first term in the White House), and better-than-expected corporate earnings, to name a few key variables.
The stock market is historically pricey
When investors attempt to value a stock, they often turn to the traditional price-to-earnings (P/E) ratio. This measure divides a company's share price by its trailing-12-month (TTM) earnings per share (EPS). It's a helpful tool for determining a stock's cheapness or priciness relative to its industry and/or the broader market.
stock market sporting one of its priciest valuations in 154 years, corporate execution needs to be flawless to maintain this rally. Unfortunately, some of Wall Street's most influential companies have an earnings quality problem -- and it simply can't be ignored any longer.
But for the broader market, a more befitting measure of value is the S&P 500's Shiller P/E Ratio, or cyclically adjusted P/E Ratio (CAPE Ratio). This measure uses average inflation-adjusted EPS over the past 10 years to smooth out shock events and allow for true apples-to-apples valuation comparisons.
price-to-earnings (P/E) ratio. This measure divides a company's share price into its trailing-12-month (TTM) earnings per share (EPS). It's a fantastic tool for quickly determining the cheapness or priciness of mature businesses, relative to its industry and/or the broader market, but it can get tripped by growth stocks and shock events that reduce EPS.
Even though the Shiller P/E Ratio wasn't created until the latter half of the 1990s, it has been back-tested to January 1871, allowing for 154 years of historic valuation comparisons.
CAPE Ratio). Instead of using TTM EPS, the Shiller P/E Ratio is based on average inflation-adjusted EPS spanning the last 10 years. This smooths out the effects of shock events and allows for true apples-to-apples valuation comparisons.
As of the closing bell on February 6, the S&P 500's Shiller P/E was a reading of 38.37, just shy of its closing high of 38.89 for the current bull market. More importantly, it represents only the third time in 154 years that this valuation tool has topped a reading of 38 during a continuous bull market.
Widening the lens a bit further, there have only been six occasions since January 1871 when the Shiller P/E has surpassed 30. Following the previous five instances, the S&P 500, Dow Jones, and/or Nasdaq Composite shed 20% to 89% of their value.
S&P 500 Shiller CAPE Ratio data by
Historically, a pricey stock market has been a harbinger of trouble to come for Wall Street for more than 150 years. That's why earnings quality from America's most influential companies is more important than ever. The problem is, a dollar in corporate profit isn't always what it's cracked up to be.
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Some of Wall Street's most influential companies have an earnings quality problem
third time in 154 years where this valuation tool has topped a reading of 38 during a continuous bull market.
Businesses that offer cutting-edge innovations and/or possess seemingly insurmountable moats and competitive advantages have led the broader market higher. However, not all of these businesses are as amazing as they appear on the surface.
half-dozen occasions since January 1871 when the Shiller P/E has surpassed 30, including the present. Following the previous five instances, the S&P 500, Dow Jones, and/or Nasdaq Composite shed 20% to 89% of their value.
An ideal example of what I'm talking about is electric vehicle (EV) maker Tesla (TSLA 3.91%), which recently reported $8.99 billion in pre-tax income for 2024. Superficially, Tesla appears to be firing on all cybernetics, with its energy generation and storage segment growing by double digits and the company registering its fifth consecutive year of generally accepted accounting principles (GAAP) profit. Most EV makers aren't even profitable.
electric vehicle (EV) maker
But if investors really delve into Tesla's operating results, they'll find that $2.76 billion of its pre-tax income came from selling regulatory tax credits to other automakers, and another roughly $1.57 billion traces back to interest income generated from its cash. The company also recorded a $600 million mark-to-market gain on the value of its Bitcoin holdings during the fourth quarter. While I'm not faulting Tesla for taking advantage of these opportunities, it's worth pointing out that more than half of its pre-tax income originates from unsustainable, non-innovative sources.
TSLA
Tesla isn't the only company with an earnings quality issue. Poor earnings quality is a widespread issue among many prominent stocks.
GAAP) profit. Most EV makers aren't even profitable.
Last week, AI-driven data-mining specialist Palantir Technologies (PLTR 0.18%) knocked Wall Street's socks off by reporting a re-acceleration of its growth rate. The company's Gotham platform, which aids federal governments with data collection and mission planning/execution, has helped propel the company's GAAP profits higher.
more than half of its pre-tax income originates from unsustainable, non-innovative sources.
But amid Palantir's double-digit sales growth and 2025 revenue guidance that handily topped Wall Street's consensus is the reality that a significant portion of its pre-tax income derives from interest income earned on its cash. Palantir reported $489.2 million in pre-tax income in 2024, $196.8 million of which was interest income. Investors don't expect a company trading at 88 times TTM sales to be generating 40% of its annual pre-tax income from an unsustainable and non-innovative source like interest income.
PLTR
Tech goliath Apple (AAPL 1.91%) serves as yet another example. The company behind the undisputed leading smartphone (iPhone) in the U.S. is expected to enjoy tailwinds from the incorporation of Apple Intelligence into its physical devices. Apple's AI model has the potential to reignite consumer interest in iPhone, Mac, and iPad.
knocked Wall Street's socks off by reporting a re-acceleration of its growth rate. The company's Gotham platform, which aids federal governments with data collection and mission planning/execution, has helped propel the company's GAAP profits higher.
Something else Apple is known for is its world-leading share repurchase program. Since the start of 2013, it's repurchased almost $750 billion worth of common stock and lowered its outstanding share count by 43% in the process. Buybacks of this magnitude help lift EPS and can make a company's stock appear more attractive to fundamentally focused investors.
$196.8 million of which was interest income. Investors don't expect a company trading at 88 times TTM sales to be generating 40% of its annual pre-tax income from an unsustainable and non-innovative source like interest income.
But in Apple's case, buybacks have masked the stalling of its physical product growth engine and a notable decline in net income. Even though its full-year EPS hasn't changed much thanks to its ongoing share repurchase program, net income has decreased from $99.8 billion in fiscal 2022 (ended Sept. 24, 2022) to $97 billion in fiscal 2023 (ended Sept. 30, 2023) to $93.7 billion in fiscal 2024 (ended Sept. 28, 2024).
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With the stock market historically pricey, corporate earnings can't be taken at face value. Regardless of how significant or influential a company might be to fueling Wall Street's rally, investors need to ensure businesses are producing quality profits and not those masked by unsustainable and non-innovative sources.
incorporation of Apple Intelligence into its physical devices. Apple's AI model has the potential to reignite consumer interest in iPhone, Mac, and iPad.
Enrichment Data:
repurchased almost $750 billion worth of its common stock and lowered its outstanding share count by 43% in the process. Buybacks of this magnitude help to lift EPS and can make a company's stock appear more attractive to fundamentally focused investors.
Overall:
The S&P 500's Shiller P/E Ratio reaching a reading of 38.37 during a continuous bull market has significant historical implications. This valuation metric, also known as the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio, compares current stock prices to average inflation-adjusted earnings over the past decade. Here are the key implications:
Historical Context
- Elevated Valuations: The Shiller P/E Ratio has only surpassed 38 a few times in its 154-year history, including the current instance. Historically, such high valuations have been associated with market corrections or significant downturns[1][2].
- Past Instances: The last two notable instances when the Shiller P/E Ratio was above 38 were in December 1999 and January 2022, both preceding significant market declines[2].
Market Implications
- Correction Potential: History suggests that when the Shiller P/E Ratio exceeds 30 during a bull market, the market often experiences a decline ranging from 20% to nearly 90%[1][2].
- Investment Strategy: Despite these indicators, long-term investors are advised to remain cautious but not necessarily exit the market. The S&P 500 has historically recovered from downturns, and quality stocks can still offer opportunities even in an expensive market[3].
Valuation and Returns
- Future Returns: High starting Shiller P/E ratios are associated with lower future returns. As the ratio increases, the worst-case scenarios worsen, and the best-case scenarios become less likely[4].
- Investor Psychology: Elevated valuations often reflect investor optimism and the "greater fool theory," where investors buy hoping someone else will pay more later[4].
In summary, while the current high Shiller P/E Ratio suggests potential for a market correction, it does not predict the timing or certainty of such an event. Long-term investors should remain cautious but consider quality stocks for potential gains over time.
- Given the stock market's historically high valuation, with the S&P 500's Shiller P/E Ratio at 38.37, it's crucial for companies to execute flawlessly to maintain the rally, as indicated by the text.
- The text mentions that some of Wall Street's most influential companies have an earnings quality problem, and this issue cannot be ignored anymore.
- To value a stock, investors often use the price-to-earnings (P/E) ratio, as stated in the text. This ratio divides a company's share price by its trailing-12-month (TTM) earnings per share (EPS).
- In line with the article, the Shiller P/E Ratio, a more suitable measure for the broader market, is based on average inflation-adjusted EPS over the past 10 years to ensure apples-to-apples valuation comparisons.