High Valuations Leave the Stock Market With No Margin for Error

If earnings don't come through, the bull market could lose steam

   
High Valuations Leave the Stock Market With No Margin for Error

How much longer can stock prices continue to rise faster than earnings?

This could prove to be a key question for investors in the second half of the year, given the extent of the disconnect between the two. With the Federal Reserve pulling back on policy stimulus, the impetus for further “multiple expansion” — i.e., rising price-to-earnings ratios — is clearly on the wane. This means that corporate earnings need to play catchup in order to justify current valuations. If they can’t, the bull market may lose some steam as we move toward 2015.

The idea that earnings need to come through for the market to perform well isn’t exactly ground-breaking. But in this case, they truly need to come through — and maybe even exceed expectations — for stocks to continue rising from their current level.

Here’s why: According to Factset, the S&P 500 is trading at 15.6 times forward earnings as of July 11. This represents a healthy premium over the five- and ten-year averages of 13.3 and 13.8, respectively. It’s also the highest the forward P/E has been in nearly a decade.

The rising P/E reflects the divergence between earnings and market prices, which is shown in the accompanying image. Price-to-book is also at its highest level since 2007, while price-to-sales has exceeded its pre-crisis peak.

factset High Valuations Leave the Stock Market With No Margin for Error
Source: Factset

Source:Factset

Elevated valuations don’t necessarily have to be a problem if earnings come in as expected. The trouble is, earnings estimates for 2015 are currently very aggressive. According to data aggregated by Factset, analysts’ collective bottom-up estimates see for growth of 11.6% in 2015, which would mark the largest increase since 2011.

Perhaps a more important consideration is that earnings estimates for a given calendar year tend to fall steadily through the end of the year in question. Over time, this has proven to be a reliable trend. For 15 of the past 19 calendar years (including 2014), estimates have closed sharply lower than where they began in the prior year. (Each estimate period includes two years; for instance, estimates for 2013 were tracked from the beginning of 2012 through the end of 2013).

The only exceptions to the trend of falling estimates were 2004 (when estimates declined in early 2003 but ticked higher through the second half of that year and 2004) and both 2005 and 2006 (when estimates rose steadily throughout each of the two-year estimate periods in question). Estimates also rose modestly for the 2011 calendar year. Otherwise, the trend in revisions has been clearly downward.

The good news is that estimates for 2015 have inched higher in recent weeks. According to Factset, the 11.6% increase it registered on July 11 is higher than the 11.4% predicted gain from June 30. We’ll need to see more of the same in order to justify current valuations.

Factset2 High Valuations Leave the Stock Market With No Margin for Error
Source: Factset

Source: Factset

Still, betting that estimates will continue to rise will put investors on the wrong side of history. And this matters now, more than most years, since valuations are already so high. The 15.6 forward P/E on the S&P 500 incorporates earnings of $119.33 for this year and $133.10 for 2015. As these numbers inevitably slide downward, valuations could move still higher even if the market stays flat.

The key issue here is that a quite a bit needs to happen for actual earnings to come in near the current estimates. A double-digit increase in 2015 requires global economic growth to recover as expected and not experience any more of the blips that occurred during the first quarter. Top-line revenue growth needs to come in at or above expectations, which requires the dollar to continue moving flat to sideways.

Companies also need to continue the current pace of cost-cutting and share buybacks, as bottom-line estimates are currently well above those for top-line revenue growth. Finally, we need to see a continued environment of low interest rates and weak commodity prices, both of which have contributed to reduced costs for U.S. companies.

This is certainly possible, and investors know well that it hasn’t paid to bet on anything but a continuation of the bull market. Further, stocks tend not to experience major corrections when the economy is expanding. As a result, this discussion of valuations doesn’t represent a bear-market prediction. Instead, investors need to keep their expectations in check and take care not to over-commit to equities. Everything needs to go right to support valuations at their current levels, and that’s a tough bet to make in any market.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2014/07/valuations-stock-market/.

©2014 InvestorPlace Media, LLC

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