While the S&P 500 has gone one way, the valuation, as measured by the 12-month forward p/e ratio, has gone another. The US equity market has continued to rise, yet its valuation has continued to improve.
Wall Street has sure been a plodder. In soldiering on it has been steadfast in its determination to claw back the ground lost in the aftermath of the dot-com bust and, in pursuit of that mission, has drawn sustenance from a consistent record of better than expected growth in corporate earnings.
In one sense the US equity market has been earnings driven but, in another, it hasn’t quite been earnings driven because its rise has failed to match the rise in earnings. For whatever reason, the equity market has been either unable to adjust or reluctant to adjust fully for the positive earnings surprises. The downward trend in the forward p/e ratio reflects this failure to adapt to the strength of earnings growth.
Nothing comparable can be observed in other major equity markets. In the Eurozone and Japan, equity markets have broadly matched the rise in earnings with the result that prospective p/e ratios have moved more or less sideways in recent years. In the UK, the trend in the forward p/e ratio for the FTSE 100 has been downward but only very modestly and nothing like that observed for the S&P 500. Moreover, if the Oil & Gas and Mining sectors are stripped out of the index, the apparent de-rating for the FTSE 100 disappears. Why then the de-rating in the US equity market?
It is hard to blame it on the excesses of the dot com boom. If those excesses are still being purged on Wall Street, why not elsewhere? Valuations were even more excessive in the Eurozone for instance and yet no comparable de-rating has occurred.
One thought is that equity market risk premiums have increased. This would depress p/e ratios. But again, why just in the US? Or rather why should risk premiums be any higher in the US than elsewhere? Also, the prospect doesn’t quite jive with what can be observed in corporate bond markets where the quality spreads on yields - which reflect risk premiums - have been narrowing.
Another thought is that current double digit rates of earnings growth are unsustainable and that the equity market is discounting the single digit rate of earnings growth that has tended to be observed over the long run (see chart below). Again, why wouldn’t that be happening in other markets?
Another possibility is that the equity market is discounting higher bond yields or the prospect of an upward sloping yield curve. If you believe in the super cycle view of commodities, you might also believe that the global economy is heading for higher inflation despite the commitment on the part of the central banks to ensuring this doesn’t happen.
Specifically, you might be tempted into believing that the Fed is less committed to inflation fighting than the MPC or the ECB. After all, the Fed does have more discretion or latitude than either of the MPC or the ECB in the setting of policy in view of its dual objective (i.e., to achieve the maximum growth that is sustainable with low inflation). On that view, the US equity market could be building in some yield premium, i.e., discounting higher yields on US Treasuries than those prevailing.
We are flying kites here. None of the arguments are all that satisfying. The truth is it is hard to account for the de-rating of the US equity market. It didn’t start with the recovery in global equity markets. It started about a year later, in fact a little before the Fed embarked on its policy of normalization.
Wall Street’s de-rating is somewhat anomalous. It does not appear to be due to the influence on the market average of one or two big sectors (as might be argued is the case for the FTSE 100). A few sectors have not experienced the de-rating but a large number have and they share no obvious common denominator. However, the de-rating does appear to be a large cap phenomenon, confined to the S&P 500 and not the S&P mid cap or the small cap indices.
To pick up on where we started, Wall Street’s rise may not have kept pace with the rise in earnings but the market has, nonetheless, behaved as if on a mission to claw back the ground lost in the aftermath of the dot-com bust and, thus far, nothing has been able to thwart it. Not two years of rising interest rates, not an oil price that has increased to levels well beyond the expectations of most of us, not turmoil in the Middle East nor a constant threat from terrorism nor any other adverse factor you can think of.
The Dow has already recouped the entire ground lost since the dot-com bust and the S&P 500 is determined to follow in its footsteps. There may be plenty of risks out there for equity markets but the valuation of the US equity market wouldn’t appear to be one of them.
Tactically, the US equity market looks somewhat extended and there may be some profit-taking. However, unless earnings lose considerable momentum - a prospect that we think is unlikely - the equity market looks set to continue its upward grind, helped by a valuation that has gone from favourable to more favourable.
* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not necessarily the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not necessarily a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.