After a bruising selloff last year, the stock market’s stellar run in the first three months of 2019 has helped to push equity valuations back to historically elevated levels, at the same time that analysts are predicting the first quarterly earnings contraction in nearly three years.
However, despite equities reasserting themselves at prices that many view as rich, strategists told MarketWatch they don’t see rising values as a significant headwind to further gains.
That belief is based on bets that the U.S. won’t be swept up in a trend of receding economic expansion that has engulfed much of the developed world and major emerging markets like China.
A world-wide slowdown also has compelled the Federal Reserve to keep key interest rates pinned to a range between 2.25% and 2.50% for at least the rest of the year, providing another factor that could buttress gains for U.S. stock indexes.
Average price to earnings ratios, or P/Es, a popular measure of stock values, for the S&P 500 index (.SPX), have risen to 16.8 times earnings for the 2019 calendar year, from 15.6 earnings for the 2018 calendar year, according to FactSet data, above the 16.3 the index has averaged over the previous 15 years.
By another measure, known as cyclically adjusted P/E, or the Shiller CAPE ratio, P/Es stand at an even higher 30.99, compared with an average of 16.61. The measure was developed by Nobel laureate economist Robert Shiller of Yale University and compares the price against inflation-adjusted earnings over the previous 10 years.
“Valuations are not that compelling,” Alec Young, managing director for global markets research at FTSE Russell told MarketWatch. Nevertheless, he doesn’t think that P/Es have risen enough to warrant investors a wholesale abandonment of stocks by average investors.
In fact, he said earnings multiples could continue to expand in a phenomenon that Wall Street analysts and technicians refer to as multiple expansion.
Brent Schutte, chief investment strategist at Northwestern Mutual Wealth Management Company agrees with those complaining about richly valued stocks, but cites the Fed’s go-slow policy pivot in January — confirmed in March — and the knock-on effect of lowered interest rates, as the ultimate justification for persistent stock-market gains, even if earnings prove lackluster.
“The central bank has shifted to where they are willing to let inflation run high rather than risk cutting off the expansion,” he said, adding that in such an environment, investors will have to get used to higher-than-average earnings multiples.
Schutte said that when investors worried about high valuations last fall, that was in the context of a central bank that had raised interest rates nine times since the end of 2015 and four times in 2018 alone.
“Stocks are expensive, but they’re rationally expensive when the 10-year treasury is yielding just 2.5%,” the Northwestern Mutual strategist said. The 10-year Treasury note yields, as of Tuesday afternoon trade, according to FactSet data.
Fed policy, led by Chairman Jerome Powell, influences rates on a range of fixed-income instruments. By keeping the Federal-funds rate low, yields on other fixed-income securities follow suit, which, in turn, can make equities a more attractive comparative investment.
Young argued Powell & Co.’s newfound wait-and-see monetary stance makes a recession unlikely in the near term, providing yet further support for high stock-market valuations. That is despite one of the most accurate recession indicators, known as the yield curve, flashing red late last month.
“We don’t have the fast growth, high inflation, or tight monetary policy that you typically have late in the economic cycle,” Young said. “There’s too much stimulus in the global economy now to expect a recession,” he said.
Some bullish strategists also claim that stock valuations aren’t inherently important, and certainly aren’t a predictive tool in timing if equity benchmarks are near a top — a point that Shiller has made numerous times. Back in September, he told Bloomberg News (paywall) in an interview that stocks were “highly priced, but it could get much more highly priced,” he said. “It’s a risky market now.”
Of course, stocks unraveled soon after Shiller’s comments, but have become resurgent in recent trade, with the S&P 500, the Dow Jones Industrial Average (.DJI), and the Nasdaq Composite Index (.IXIC), within 3 percentage points of records, or closer, of all-time highs.
Although stock valuation is an important consideration for long term investors, in the short term, they aren’t a useful indicator, according to Jill Carey Hall, equity and quantitative strategist at Bank of America Merrill Lynch. “We find that valuations have very little predictive power over stock performance over the next quarter or year,” she said. “In the short term sentiment and positioning are more important.”
Craig Callahan, founder and president of Icon Investments illustrated this fact in a study published last year, where he found that P/E ratios for the S&P 500 explain less than 5% of the index’s subsequent performance.
As the scatter plot above shows, there is very little relationship between P/Es and the 12-month forward return for the S&P 500.
|For more news you can use to help guide your financial life, visit our Insights page.|