The Valuation Conundrum

by: Eric Parnell, CFA


The stock market has a weight problem.

The recent stock market bounce has been impressive, but it also lacks substance.

Even with a commensurate increase in earnings going forward, stocks may eventually find themselves in for an unsettling slide to the downside.

The stock market has a weight problem. The rise from the post financial crisis lows of March 2009 has been remarkable. And more recently, the continued resilience of a stock market that has already set the mark for the third longest bull run in history has been equally impressive. But the growing problem for the U.S. stock market as we move further into 2016 is that it is increasingly lacking any substance behind its latest advance. For if investors ultimately decide that they do not wish to pay more and more for each dollar of declining earnings, the market may eventually find itself in for an unsettling slide to the downside.

Following the latest bounce back, the S&P 500 Index (NYSEARCA:SPY) is now trading at 23.7 times trailing 12-month as reported earnings. To put this current valuation in perspective, the stock market has traded at a historical average of just below 16 times trailing 12-month as reported earnings. In other words, the stock market is currently trading at about a 50% premium to its historical valuation, which is a level it has reached only three other times in the last 150 years. And it is doing so in an environment marked by consistently sluggish growth in the aftermath of the worst financial trauma for the global economy in nearly a century. In addition, these premium valuations exist along with underlying earnings growth that has been declining on an annual basis for the last four quarters and are projected to continue falling for at least the next two quarters. In short, the "P" in the P/E ratio is getting bigger at a time when the "E" is getting smaller. Such is typically a bad combination for future stock price increases.

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How about those analysts on my television set that keep calling for higher stock prices such as a 2200 to 2300 level on the S&P 500 by the end of the year? This is certainly possible - anything, after all, is possible in the post crisis financial markets - but it would require at least one of the following. First, it would require that future earnings growth accelerate from already ambitious forecasts. These same analysts often cite the forward P/E ratio on the S&P 500 Index, which is based on earnings forecasts over the coming year that habitually fall well short of expectations as time passes from projections to reality. But even if we were to assume these forecasts were to come to pass, the forward P/E ratio on the S&P 500 Index as of 12/31/2016 is currently 18.4 times earnings, which is historically very high in its own right. And that assumes that the price of the market goes nowhere for the rest of the year. If the market were to surge to 2300 by the end of the year as some analysts suggest, this would have the S&P 500 Index trading at 20.6 times trailing 12-month as reported earnings assuming the rosy forward earnings forecasts prove correct. These are ambitious expectations to say the least.

But isn't the recent weakness in S&P 500 Index earnings largely attributable to the drag from the energy (NYSEARCA:XLE) and materials (NYSEARCA:XLB) sectors? Once this reverses, won't earnings naturally bounce back? Perhaps, but it has been more than just the commodities sectors that have been languishing from an earnings perspective. In fact, many other major market sectors including industrials (NYSEARCA:XLI), consumer staples (NYSEARCA:XLP), health care (NYSEARCA:XLV), financials (NYSEARCA:XLF) and technology (NYSEARCA:XLK) have all been languishing in the low to mid single digits in terms of operating earnings growth over the past calendar. And this comes in an environment that has been generously supported by Federal Reserve policies that have promoted aggressive low cost debt issuance and share buyback activity, both of which are meaningfully supportive to earnings growth. In short, a return to over +$100 earnings to as high as +$120 by the end of 2017 on the S&P 500 Index assumes that companies can not only reverse the fading trend of earnings growth but also do so organically instead of via policy support at the same time that the commodities sectors suddenly get back on their feet and start making decent money again. Once again, ambitious expectations.

Instead of forecasts for sunshine and lollipops, let's assume for a moment that conditions simply stabilize and stay where they are right now at around $87 per share. No recession. No further -15% decline in annual as reported earnings growth like we have seen over the past year. Instead, conditions just hold generally steady. We still have a market that at 23.7 times earnings is trading at a 50% premium to its historical average valuation. Supposedly, we are operating in a There Is No Alternative to U.S. stocks, or TINA, market. But what if an alternative were to present itself? Or what if investors eventually decided that the downside risks had become too great to owning stocks with such a high multiple and decided that holding cash was the better option instead - after all, a -0.1% return is better than a -20% return? What then?

A recent memory that remains vividly in my mind was how quickly institutional sentiment changed during the financial crisis. At the peak of the market in the summer of 2007, investors justified holding stocks at all-time highs at the time because they were trading at around 16 to 17 times trailing 12-month earnings, which was roughly in line with historical averages. But by the time that the financial crisis had full descended just over a year later, the added risks had investors proclaiming that a 10 to 12 times market multiple was more justified. Put more simply, investor sentiment when it comes to valuation can change quickly. And when investors are holding stocks when they are trading at very high multiples as they are today, any such future adjustment will prove tremendously painful.

As mentioned before, today's market is trading at 23.7 times trailing 12-month as reported earnings. Now let's just assume that increased risks, higher market interest rates or any number of other factors caused investors to take down their multiples on the market. For the sake of discussion, let's just suppose in our no recession stabilization scenario that the market was simply repriced back to 18 times earnings, which is the level that it was holding up until the end of QE3 back in the fall of 2014. What price level does this imply on the S&P 500 Index? A return to its previous all-time highs in the 1550 to 1575, which is -23% below current levels.

Now let's suppose investors in our no recession stabilization scenario opt to reprice the market to its historical average at around 16 times trailing 12-month as reported earnings. Nothing outlandish here, just simply a return to the long-term average. This implies a price on the S&P 500 Index in the 1375 to 1400 range, which is -32% below current levels.

For the sake of discussion, let's take things one step further. Instead of earnings holding steady, let's suppose that they decline further to say $70 per share on the S&P 500 Index, perhaps under a mild U.S. recession scenario. Once again, nothing outlandish, as such a drop on S&P earnings would represent nothing more than a return to the long-term trendline for S&P 500 as reported earnings. And being generous, let's assume that interest rates remain low and investors can justify still owning stocks at a reasonable premium multiple at around 17 to 18 times trailing 12-month as reported earnings. What does this still fairly reasonable scenario imply for a price level on the S&P 500 Index? A shift to the 1200 to 1250 range on the S&P 500 Index, which is just over -40% below current levels.

The Bottom Line

One could go further and much deeper with the scenarios being presented above, but they all lead to the same underlying point. Today's stock market is expensive. And while it may become more expensive in the near-term before it's all said and done, the laws of gravity imply a greater probability for a sustained move to the downside over a continued move to the upside in the intermediate-term to long-term. As a result, stock investors should maintain caution moving forward, for the path to future gains is now far more challenged than the seven years that have come before.

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Disclaimer: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.