At Cambridge, we analyze a company's source of growth to look for sustainability. The same analysis can be used when looking at the market by assessing drivers of returns.
With strong performance across markets so far this year, we decided to dissect returns to find out what has been driving them. Is it earnings growth or multiple expansion? You can see the results below:
*Source of data: Bloomberg. Returns calculated by aggregating individual stock data.
It is pretty clear; multiple expansion has driven the markets this year. This, in and of itself, is no reason to be nervous. First of all, it depends on your starting point. In the U.S., the S&P 500 Index moved from being attractive to fairly valued at about 15 times forward expected earnings (although stocks still offer better value than fixed-income). Second, the market does move ahead of fundamentals and earnings revisions. However, because of where we are in the cycle (four years into recovery) and the dual spikes in interest rates and oil over the last few months, it’s tough to argue for a significant reacceleration in earnings growth today.
It is also worth taking a look across different sectors to see how expectations have changed. In the U.S., multiple expansion has occurred in cyclical areas (industrials, technology, financials and consumer discretionary) as the economic expectations have improved. Health care has also seen significant multiple expansion as U.S. deficit concerns have been reduced. In Canada, we can see similar results. However, multiples in the materials sector have expanded dramatically because earnings expectations declined with prices across the complex. This is a sign to take another look at this space.
By breaking down returns into their component parts, we can better judge how expectations have changed and rebalance our portfolios towards the best risk-reward opportunities available. As bottom-up investors, we are much more confident when we can find solid fundamental stories where earnings growth and value creation can deliver returns rather than hoping multiple expansion will do the job for us.