Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.
– Peter Lynch
There has been much discussion these days about valuations within equity markets, specifically as it pertains to the trailing price/earnings (P/E) ratio of the S&P 500. At the time of writing, the trailing P/E sits at 32 times, well above its longer-term average of closer to 18. However, does that mean an immediate reversal is warranted?
The strong move higher in valuation, using the S&P 500 Index as our benchmark, from the equity market lows last year shouldn’t come as a surprise. We experienced three quarters of negative earnings growth on a year-over-year basis at a time when the U.S. government and the Federal Reserve were providing ample liquidity to the economy, stoking the coals of an economic recovery. The Fed has been very successful with this iteration of quantitative easing, with the money supply (as measured by M2) up 25% year-over-year. When the money supply increases, stock prices tend to go up. We can point to some segments of the market that are overvalued or overextended but we’d hesitate to characterize the broader market as in a bubble.
How thick is the ice?
When using an analogy for broad equity market valuation, I prefer to think of it as a lake that has frozen over rather than a bubble that grows until it pops.
When a lake begins to freeze, it’s typically gradual, and it tends to thicken as the weather gets colder. The biggest risk is not knowing how thick the ice is, as you can’t see that from the surface. If you don’t know how thick the ice is, how willing would you be to walk (or snowmobile) to the middle of the lake? If the ice is too thin, there’s a bigger risk that it might crack. You don’t know when, where, or how it will crack, but the risk is elevated as the ice starts to thin out. Could the same be said about equity market valuation: the more stretched the valuation, the thinner the ice and the greater the risk?
Ask any market participant their preferred measure of valuation and you may receive countless variations. In our experience, we don’t believe there’s one perfect measure of market valuation, and regardless of which measure you choose, there seems to always be a reversion to the mean over time. Many of these metrics are simply ratios with two numbers, a numerator (first number) and a denominator (second number). A shift by either the numerator or denominator can dramatically change valuation.
When looking at various measures of valuation — price-to-book, price-to-sales, price-to-cash flow, price-to-earnings — they each tell the same story: the S&P 500 is toward the upper range of its 20-year history. These stretched valuations are what’s driving the fear of a potential valuation correction in the equity markets. At these levels, it would appear that markets are priced for perfection, or to use the analogy, we’re walking on thin ice and any misstep may cause a crack.
We’ve seen enough periods of over- and under-valuation last for many years to make the conclusion that valuation is a poor predictor of shorter-term performance or short-term risk of corrections. However, valuation can play a role in framing expectations of investment returns over longer periods of time. At today's low annualized inflation rate and low interest rates, the appeal of equities, despite overvaluation risk, isn’t surprising.
When it comes to valuation, the true measure of thickness comes down to how strong the supporting data is. Although the current market valuation looks to be on thin ice, we’d argue that it’s supported by improving fundamental data.
A strong equity market recovery is typically started by a valuation expansion then followed by a transition to an earnings recovery. In an earnings recovery, we tend to see valuations contract. This valuation contraction occurs in an orderly fashion as earnings grow into the valuation. Our work shows that during periods when earnings growth is greater than 30% on a year-over-year basis (as we believe it will be in 2021), the average price-to-earnings contraction is 4.1 multiple points. During these periods, and despite the fall in valuation, the average and median 12-month returns for the S&P 500 Index are 10.2% and 12.4% respectively.
We believe 2021 will be no different. As we mentioned in our key themes for 2021 article, after three quarters of negative year-over-year earnings per share growth, the earnings recovery has begun. We’re approximately 77% of the way through the fourth quarter earnings releases for S&P 500 companies and the results are showing promise. With 386 companies having reported at the time of writing, earnings growth is coming in at a better-than-expected 6.03%, with sales growth gaining 2.75% year-over-year. We believe 2021 earnings may not only reach 2019 levels but exceed them, supported by strong fundamentals.
Earlier this month we saw continued strength in the U.S. manufacturing economy, with the Institute for Supply Management Manufacturing Purchasing Managers Index (ISM PMI) showing a reading of 58.7 for the month of January. It was a tick lower from the recovery high of 60.5 for December, yet still at a very encouraging level for forward earnings growth. Recall that one of the Capital Market Strategy team’s favourite indicators is the ISM PMI because of its ability to forecast trends in S&P 500 earnings growth.
Valuation, regardless of the method of calculation, can’t indicate by itself how thick or thin the ice is. You need to be able to see what’s supporting that top layer. We’ve had times when valuation levels were below where we are today and would be cause for extreme caution. However, because of the strong underlying support and the expected positive market environment in 2021, the ice is probably a lot thicker than it may appear.
Kevin Headland, CIM
Senior Investment Strategist
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