Are U.S. stocks cheap, expensive, or fairly valued?

From Nick Colas, Chief Strategist at Convergex, discusses valuation:


Are U.S. stocks cheap, expensive, or fairly valued?  Here are our 5 discussion points:

Point #1: At 16.8x a projected $131/share in earnings for the S&P 500, U.S. stocks are no one’s idea of “Cheap”.  As FactSet points out in this week’s Earnings Insight, this is higher than the 5 year average of 15.0x and the 10 year average of 14.3x. Importantly, that 16.8x comes at a time when interest rates are rising rather than falling (as they generally have over the last 10 years).  Higher interest rates lower the present value of future earnings, after all.  And that should mean lower valuations.

The latest FactSet report is here (P/E analysis on page 6):

Some of our readers also use the Shiller PE, a measure of long term (10 year average) earnings power.  By that measure the S&P 500 trades for 27.6x earnings, the high end of its post-2000 stock bubble range.  You can see the long term (1860 – present) chart here:

Point #2: Trends in expected 2017 corporate earnings are helping the case for stocks, however.  FactSet shows that top-down estimates (those made by strategists rather than single stock analysts) are starting to turn higher in the last few weeks, up about $1/share to that $131/share number we cited in Point #1. 

Not to encourage you to stop reading, but this is pretty much all you need to know about the current rally in U.S. stocks. Investors are buying in to the notion that a Trump presidency/Republican Congress can move the needle on business and personal tax cuts, infrastructure spending, and reduced regulatory burdens across multiple sectors.  All that adds up to greater earnings power, and that $1/share bump from the Wall Street strategist crowd is a nod to that belief.

Point #3: For a market used to dividend increases and stock buybacks to backstop valuations, this new world order will take some time to fully digest.  A few highlights to expand on this statement:

  • According to S&P, the companies of the S&P 500 are currently paying out 44.3% of their earnings in dividends. This is much higher than the 38.7% average back to 1988 and more akin to the payouts we see during recessions.  The difference here is that profit margins (currently 10.0% according to S&P) are much closer to cyclical peaks than troughs.  For a comparison, consider that payout ratios during the 2006-2007 cyclical peaks were 26-33%.  If you want to see the whole time series, shoot us an email and we will send it over.
  • FactSet’s Buyback Quarterly points out that 137 of the S&P 500 (27%) bought back more stock in the four quarters ending Q2 2016 than they generated in earnings. Factset also noted than in Q2 (most recent data available) some 350 companies in the index bought back stock (70%), down from 380 in Q2 2015. See here for more:
  • The intersection of earnings growth (Point #2) and stock buybacks/dividends is simple: if the U.S. economy is really going to accelerate in 2017, then public companies will likely choose (at the margin) to reinvest in their businesses rather than hand back cash to shareholders. That’s a big deal for an investor base that has grown accustomed to earnings that end up in their pocket rather than retained by management.  Like Veruca Salt, this group tends to want it all.  And they want it now.

Point #4: The next few quarters are setting up as a cyclical investor’s dream, but like all dreams they require some interpretation.  The key sectors to watch are Financials (+9.7% on the year) and Industrials (+17.5% YTD).  Both have underperformed the S&P 500 over the last decade, and both have caught a bid since President Elect Trump’s win. 

The funny thing about cyclical stocks is that investors give them far more leeway than other sectors during an expected upswing.  For those of you with graying muzzles, think back to the early 1990s U.S. equity market when auto, airline, industrial and banking stocks had multi-year runs.  Markets discounted expected earnings that wouldn’t hit the tape for 4-8 quarters.  For those of you accustomed to tech or health care stocks that swoon when they miss earnings by a penny or a dime, this is a whole new kettle of fish. 

Point #5: For the most concentrated exposure to Industrials and Financials, look at the S&P 600 Small Cap index.  These sectors make up 35% of the 600: Industrials at 18.1% and Financials at 17.0%.  The S&P 500 Large Cap index is only 23% exposed to those same sectors: Financials at 13.3% and Industrials at 9.7%.  You can check out the fact sheets here (free login required):

To summarize, let’s remember where we started: valuation, which is the analysis of investor expectations as they relate to asset prices.  At first blush, the “Trump rally” feels like it has stretched U.S. valuations beyond reason.  The simple math of a 17x PE in a rising rate environment is proof enough of that. 

The truth is more nuanced, for in reality the whole framework of market expectations has shifted, and rapidly at that.  Investors will have to adapt to a world where the companies they own do some investing as well rather than hand back all their earnings in buybacks and dividends.  And sectors like Financials and Industrials, long forgotten, may once again show a cyclical resilience out of pace with their near term fundamentals.

One thing is for sure: the recent rally is more than just an uptick in asset prices.

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