How can one be long U.S. stocks when the Price Earnings Ratios (PE) is close to bubble-like levels? After a year when more than three quarters of stock returns were driven by a rise in earnings multiples, how could 2014 provide investors with double digit returns given the levels of valuation?
The answer is simple: the U.S. equity market can provide decent returns without suffering any significant rise of PE above the 17x threshold.
The total return on equity can be broken down into three elements:
i. Change in absolute price earnings ratio (∆PE)
ii. Change in earnings (∆E)
iii. The divided-to-price ratio at the end of period.
For investors wary of buying an already expensive stock market, one has to assume that ∆PE will be equal to zero in 2014 (or marginally positive) and that the whole return contribution will come from changes in earnings.
Before I explore this option, I would like to stress that the current PE is still below the 16x threshold, which would suggests that the risk of over-valuation, albeit real, has not yet materialized.
There is a rationale for a limited potential increase in earnings per share (EPS) in 2014. It is based on a simple observation: given that the profit-share of GDP stands at a historical level, macroeconomic profits should be rising at the pace of nominal GDP, at best. I use pre-tax profits as an indicator of the ability of businesses to generate revenue the after-tax profit stands today 2 points of GDP above the previous peak of 2007.
Assuming a 5% nominal GDP growth for 2014, U.S. GDP would lead to an earnings growth (∆E) equal to 5% plus or minus a listed premium. The listed premium is the ability of listed company to reap extra growth in earnings due to their exposure to global markets. Yet, it can also be negative, as can be seen below, for reasons linked to FX volatility, for instance. I would therefore bet on a 5% growth in EPS.
Interestingly enough, the current trend of U.S. PMI would suggest EPS growth to be much higher. As can be seen below, there is a strong link between EPS year-over-year growth forecast and the yearly change of the ISM Manufacturing. The ISM might ease down in the near term but it should not be detrimental to an EPS growth forecast that seems conservative.
Lastly, a simple model of EPS forward growth based on traditional macro data (global PMI, USD, U.S. Treasury yields and nominal growth) suggests that the potential for a sharp retrenchment for ∆E is limited. The forecasts are based on a stronger dollar and slightly higher U.S. Treasury yields, which explains the downward trend in spite of my positive view on U.S. GDP growth (2.5% in 2014).
The second leg of returns would be the dividend yield. Currently at 1.9%, I assume that it will remain at this level throughout 2014, given its stability since 2010.
Bottom line: The potential for U.S. stocks to register a total return of 7% (stable PE, 5% rise in EPS and 2% dividend yield) in 2014 is consistent with very conservative macroeconomic assumptions. Given than valuations may have some room to edge up and that forward EPS are currently underpricing the signal sent by the ISM, a 10% total return should not be ruled out.
There is a risk that long term yields may overshoot but 1/ the risk premium is still wide and can absorb this shock; and 2/ the UST yields and S&P 500 returns correlation should return to positive territory once the uncertainty on the future path of monetary policy has eased.