The rebound in corporate earnings and the recent drop in bond yields are helping to moderate valuations of US equities, reinforcing the case for buying stocks, even when markets are close to the records and economic growth is expected to slow.
The benchmark S&P 500 index is up more than 17% so far this year, despite concerns about rising inflation and the expected slowdown in economic growth.
At the same time, however, stock valuations have declined since the beginning of the year. The price / earnings (P / E) ratio of the S&P 500, a commonly used measure of market valuation, stands at 21.4 times earnings estimates for the next 12 months, according to Refinitiv Datastream. It is still well above its historical average of 15.4 times, but below January’s 22.7 times level.
On the other hand, the rebound in Treasury markets, which has caused the yield on the 10-year Treasury note to fall 50 basis points since the end of March, as bond prices soared, has also contributed to increase the attractiveness of stocks as an investment.
“I think the stock market is still the place to be,” said Peter Tuz, president of Chase Investment Counsel in Charlottesville, Virginia. “Although valuations are high, fundamentals are good, most companies are having excellent quarters and the outlook is quite good.”
The focus on valuations comes as investors assess various cross-currents that may influence markets in the coming months, such as the expected slowdown in growth, the resurgence of COVID-19 cases in the US and plans to the Federal Reserve to undo easy money policies that have helped sustain asset prices since the March 2020 pandemic-driven selloff.
Investors will get a new snapshot of the economy next week with the monthly US employment report and another batch of earnings reports from companies like Eli Lilly, CVS Health and General Motors.
Expectations of strong future earnings have been the main driver of the S&P 500’s earnings this year, according to a Credit Suisse analysis of the index’s performance so far this year, comparing the change in stock valuations against changes in expected benefits.
The fact that earnings continue to be better than expected is in a position to keep valuations under control. According to Refinitiv IBES, earnings are expected to increase 87.2% in the second quarter, compared to forecasts of 65.4% in early July.
“If we have an environment like the one we have, where companies are beating expectations by 18-20%, that means the PER is lower than the official figure,” said Jonathan Golub, chief US equity strategist at Credit Suisse. Credit Suisse projects the S&P 500 to end the year at 4,600, roughly 4% above Thursday’s close of 4,419.15.
Alphabet, Google’s parent company, and Boeing have been some of the biggest winners of the season. Investors were less satisfied with Thursday’s report from e-commerce giant Amazon, whose shares took a hit after it said sales growth would slow in the coming quarters.
The fall in bond yields, with the 10-year yield recently falling to about 1.25%, has also boosted the relative attractiveness of equities.
The equity risk premium – comparing the return on equity earnings to the interest rate on bonds – is currently at a level that has historically been an average 12-month gain on the 15th S&P 500. 2%, according to the Wells Fargo Investment Institute.
Goldman Sachs said in a recent note that its year-end S&P 500 target of 4,300 is based on a 1.9% 10-year yield. A return of 1.6%, still more than 30 basis points above current yields, would raise Goldman’s fair value estimate for the S&P to 4,700 by year-end, keeping modeled growth and other factors constant, the report said. Bank.
However, some investors have been nervous about stock valuations, which are high by many historical measures, despite recent earnings successes.
One of the valuation measures that emits warning signals is the cyclically adjusted price-earnings ratio, or CAPE ratio, which takes a longer-term perspective to adjust for swings in business cycles. It has risen to its highest level in more than 20 years.
The increase in the CAPE ratio was one of the factors that Cresset Capital Management considered before modestly reducing its global equity exposure earlier this year for its portfolios that have an investment horizon of at least 7 years, said the Cresset’s chief investment officer, Jack Ablin.
“Stock valuations are expensive, extremely expensive,” he said. “From that point of view, the market does not have a very compelling long-term future.”
(Reporting by Lewis Krauskopf; editing by Ira Iosebashvili and Dan Grebler) .. Translate serenitymarkets