dreaming about future earnings

That’s what growth investors mostly do. There are situations, mostly at market bottoms (and around the low point of the business cycle), where even the best long-term growth companies are trading at a price justified by today’s earnings alone. As the economy recovers ands earnings begin to expand again, growth stocks begin to go up. Two reasons commonly cited: increasing earnings and expansion of the PE multiple–the latter being whatever is not explained by expectations for current earnings growth.

There’s another, more informative, I think, way of looking at PE expansion. As the market turns increasingly bullish, investors (who can no longer justify buying a stock based on current earnings) begin to also factor into today’s price their expectations for next year’s earnings. Sometimes, when the market is feeling extra-bullish–and when stocks seem otherwise too expensive–the market begins to factor into today’s price expectations for earnings two years in the future.

Take Nvidia (NVDA) as an example:

expected 2024 earnings = $3.00, meaning a PE of 47x

expected 2025 earnings = $4.50, meaning a PE of 31x

projected 2026 earnings = $7.00-ish, meaning a PE of 20x.

A simple-minded (though pretty useful, I think) gauge of the value of stocks vs government bonds, is the comparison of the earnings yield on stocks (meaning 1/PE) vs. the interest yield on the 10-year Treasury note–now 4.5%.

a PE of 47 = earnings yield of 2.1%

a PE of 31 = earnings yield of 3.2%

a PE of 20 = earnings yield of 5.0%.

On this measure, NVDA looks expensive based on the assumption of a strong finish to 2024 and 50% yoy earnings growth in 2024 but reasonably priced if we also throw in another 50% eps growth in calendar 2026.

This may well end up as the actual outcome. If so, the stock will likely be considerably higher two Decembers from now than it is today. This may also be the most probable scenario. My point, though, is that the US stock market is usually much more comfortable making bets on what will happen by this December than on what will occur almost two years from now.

So I don’t think there’s a lot of room for many stocks to move higher because investment horizons continue to expand (in the case of NVDA, I’ve sold well over half of the position I’ve held since January 2019).

It’s also possible that horizons will contract, at least partly because they most often do once they get to current heights. In addition, the administration in Washington seems to think that raising the price of imported materials and shrinking the number of workers in the country will somehow end up stimulating economic growth. Let’s hope so, even though conventional wisdom argues the opposite.

My sense is that the typical horizon contraction is already underway. If so, steadier but more pedestrian growers may become more appealing, down-market retailers vs. up-market, as well as down-and-out, you-can’t-fall-off-the-floor value stocks. Intel as a breakup candidate may be another indicator.