Market Rally Built on Multiple Expansion, Not Earnings Growth - David Rosenberg

David Rosenberg is out with a bearish piece on equities today (I hope that doesn’t surprise you). He sees the market as still overvalued at these levels. The key, he says, is that most of the rally has been built on multiple expansion and not earnings growth. Here is what he says (emphasis added):

We heard at the market lows in March 2009 that the stock market had sunk to Armageddon levels. We have often thought about that because we can certainly understand that at the 2.0% lows on the 10-year Treasury note yield, we had gone to a place we had not seen in over five decades. Also, with Baa spreads north of 600bps, we could see that corporate bonds had moved to levels not seen in seven decades as well.

But this notion that we had moved to Armageddon lows in equities does not seem to hold water. After all, the forward P/E multiple on the S&P 500 at the lows was 11.7x. That was not a multi-decade low or some massive standard-deviation figure — we were actually lower than that at the October 1990 lows when the multiple was 10.5x and frankly, coming off the 1987 collapse, the forward P/E had compressed to 9.8x. As it now stands, the multiple is back very close to where it was at the October 2007 market high, when the multiple had expanded to 15.0x. The range on the forward P/E over the last quarter-century is between 9.8x and 21.8x (excluding the tech bubble), so at 14.5x currently, it is hardly the case that this market can be viewed as a bargain.

On a trailing earnings basis, the P/E multiple has actually widened, from 17.0x at the lows to 23.3x currently, a huge multiple expansion. At this stage of the 2003 recovery, the multiple hardly expanded at all, earnings were driving the rebound; coming off the October 1990 lows, the multiple expansion four months into the rally was closer to 2x and the powerful surge in the post-1982 recovery saw a 3x multiple point expansion at this juncture — not 6x!

Back in November 2007, just as the recession was about to take hold, John Mauldin commented that 80% of the stock price appreciation in the 1980s and 1990s bull market came from multiple expansion (also see his May 2006 piece with research from Jeremy Grantham on this). So, obviously, multiple expansion is part and parcel of the psychology of secular bull markets. However, Rosenberg’s piece reveals that all secular bull markets in the U.S. for which data is available have started from price-earnings multiples that are much lower than we are seeing at present. Translation: this is not a secular bull market.

What we have seen since March is a bear market rally, nothing more.

Source

Multiple-Led Market May Meander – David Rosenberg

Comments

[coldcall:]

Totally agreed. Its almost shocking how punters have bought into this 100% hyped rally since March. The way oil went up in the middle of worst recesision since 30's is staggering. Its like a last hurrah.

Current P/Es are out of their minds considering the state of western economies.

Jul 07 02:40 PM

[whidbey:]

Interesting history , I have looked at as well and I am very reserved when it occurs. Multiple expansion comes in most cases from anticipation of future events - expectations of growth - recovery. But the market, as you noted, is not cheap. In fact, it is setup for a raging disappointment if the stimulus does not take hold soon. It won't, so I suspect we go down in the fall, but not before a little more celebration after this little dip to 810 or so. Thanks.

Jul 07 02:43 PM

[Larry House:]

Sobering but true. If the forecast by Bill Gross and others that growth will be in the 1-2% range for years--when growth finally returns--at what multiple will S&P earnings be valued? First, we haven't started growing yet. Also, a case could be made that we could be close to the top or there once we see where earnings will come in. No wonder Bill Gross and others have been saying returns on equities may be subpar for years to come.

Jul 07 03:07 PM

[John Lounsbury:]

Edward - - -

I am pleased you picked up this newsletter from Rosenberg; it is very worthwhile.

whidbey and Larry - - -

You have brought up one of the primary logical reasons for multiple expansion (future earnings growth) and the questions that exist about whether or not that will be robust enough to support higher multiples.

There is another driver of higher multiples and that is lower interest rates. From a fundamental analysis point of view, stocks are valued based on anticipated future earnings (growth discussed above) discounted by the risk free return (usually short-term treasuries - although some analysts use the 10-year treasury). This driver of PE expansion has poor prospects in the coming years. The only way interest rates can go lower is if there is continued inflation, which would be accompanied by lower corporate earnings under most scenarios.

Disclaimer: This entire discussion (article and comments) is based on logic. Sometimes the market is not logical. I cite irrational exuberance and panic selling as examples.

Jul 08 12:34 PM