Valuations across this market have grown quite high, given the 20%+ run in stocks this year without any gain in earnings. For stocks to maintain this level or advance, we need more than just liquidity injections from the Fed. We need a revival in economic growth and upside surprises in earnings. Markets rallied this week on buoyant US employment data releases. Combine these with improvements in data out of Europe and China and economic outlooks may be brightening. A growth revival for corporate earnings would help justify today’s lofty valuations. Higher hopes for better economics drove markets higher this week…and at these levels, higher earnings are not a luxury; they are a necessity.
Friday’s job release deserves attention and appreciation. Employers added 266,000 jobs in November, well above economists’ expectations of 180,000 jobs. The unemployment rate fell to a cycle low of 3.5%, a level last seen in 1969. This data confirms a very robust weekly jobless claims report received on Thursday and correlates with brightening economic prospects offshore. Furthermore, a robust US labor market portends a solid holiday season for US retailers, reducing recession probabilities as we enter 2020. Meanwhile, the Fed has taken a self-imposed sabbatical, noting that it will openly tolerate higher inflation levels and doesn’t see a need to adjust rates for a while. Sounds like a nicely neutral stance but dig deeper. The Fed has quietly printed $300 billion in the last three months to fund asset purchases. That’s a massive injection of liquidity (also slated to continue into Q2 2020), and the source of the market’s record high resumption. However, for the market advance to continue, we need evidence of economic revival. The combination of this week’s jubilant jobs report with better Chinese and European data may depict a global economy on the mend. Throw in possible trade concessions and a recovery in capital spending, and we could see another leg to this already historic economic advance. One monthly report cannot claim a trend, but this one indeed was a surprise and will lead market mavens to revise their 2020 models and predictions…upward.
What’s Been Pegging Me
In a couple of weeks, I will be in NYC meeting with media outlets to discuss markets and our outlook for the year ahead. I still have more work to do. Therefore, none of these comments should be considered conclusive, but I will share with you the one variable that keeps reappearing in my mind around 3:00 am.
Any market forecast must include an appraisal of valuation. Currently, the S&P 500 trades at a trailing price-to-earnings (P/E) ratio of 20 times. Is this number high? Yes, relative to the valuation history of the stock market. In fact, trailing P/Es haven’t consistently held above 20 during an expansion over the last 100 years (recessions cause high P/Es as earnings collapse) beyond the “irrational exuberance” market of the late 1990s.
Clearly trailing P/E valuations seem historically high, but valuations compared to themselves don’t really tell the tale. To properly evaluate trailing P/E ratio levels, we must compare them with longer-term interest rates as stocks and bonds compete for capital. When viewed through this dimension, valuations don’t appear unreasonable:
Remember that we can compare stock/bond valuations by inverting the stock market P/E to produce an earnings yield. Inverting the current trailing P/E gives us an earnings yield of 5% to compare with the 10-year Treasury yield at 1.8%. By this comparison, the market looks cheap.
Most analysts disregard trailing P/Es and look at forward P/Es. Currently, the S&P 500 trades at a forward P/E of 18 times estimated operating earnings. Is this number high? Yes, relative to the valuation history of the stock market.
But, just like our trailing P/E analysis, we need to add another variable to improve our perspective. Forward P/E ratios by design include analyst earnings expectations. Therefore, to properly appraise forward P/E levels, we must properly appraise near term earnings growth prospects. Comparing P/Es with growth prospects gives us a P/E to growth ratio or PEG. Here is a long run PEG chart for the S&P 500:
Let’s start below the line. Past opportunities to buy $1 worth of growth for less than $1 have handsomely rewarded investors (see 1990, 2008, and 2011). In fact, the PEG discount offered in late 2018 greatly informed our bullish call on markets for 2019. Unfortunately, above the line, the information becomes a little less visually translatable due to recession and down-market distortions…but take note of recent extremes. The lofty PEG ratio in 2016 required either a surge in earnings or a meaningful correction in prices for mean reversion. Fortunately, the Trump tax cut provided the requisite earnings surge which renewed the market’s ascent and rapidly reduced the PEG ratio. Unfortunately, this year the dramatic move higher in stock prices has accompanied a negligible gain for earnings, pressing the PEG ratio higher. Additionally, analyst earnings outlooks over the next few years incorporate a recession and subsequent earnings weakness. This lifts our current PEG ratio back to 2016 levels. For mean reversion, the lofty PEG ratio in 2019 requires either a surge in earnings or a correction in prices just like 2016. Which will it be?
See why this has been keeping me up at night?
Have a great weekend,
David S. Waddell
CEO, Chief Investment Strategist