There’s a curious anomaly in the US stock market. Shares of highly profitable companies have risen more slowly than their earnings growth has in recent years. This is an important signpost for investors in today’s complex market conditions.

Even after the recent correction and modest bump to earnings from tax reform, US stocks still appear somewhat expensive. Beneath the surface, there are unseen imbalances that have been created by the multiyear bull run. For example, over the past six years, the total return of the S&P 500 Index has outpaced earnings growth of the S&P by a wide margin (Display, green lines). Yet for stocks of companies with high profitability, as measured by returns on assets (ROA), the reverse is true (Display, blue lines). While shares of high-ROA companies have advanced along with the broad market, the pace of their gains has lagged far behind their earnings growth.

Post-Correction Valuations Remain Elevated

How can we explain these trends? In our view, the broad market includes many companies that have modestly increased earnings growth, with stock valuations that have risen much more than earnings have.

Companies like these are especially common in sectors seen as bond proxies, such as consumer staples, utilities and real estate. Investors have flocked to these sectors in recent years in search of dividend yield. Yet even after the recent market correction in early February, the valuations of these companies remain elevated. US utilities stocks ended February trading at 16 times 2018 earnings estimates, while consumer staples stocks traded at 17.8 times. The chart above suggests that S&P 500 companies—in aggregate—would need to generate a lot of earnings growth to catch up with share-price returns. These days, when US operating margins are quite high at 16.7%, that’s a tall order.

High margins also challenge companies that are sensitive to economic cycles. These include industrials and materials groups whose stock valuations have increased on expectations that the global profit cycle will be robust. The profitability of companies like these is often very volatile and tends to revert to the mean—especially given today’s environment of high operating margins.