Published On: Sat, May 30th, 2015

As stock valuations swell, market outlook sours

 

Story image for todays news on stock from USA TODAY

 

Six years into the bull run on Wall Street, rising stock valuations are now being cited as one of the “biggest impediments” to the market’s continued advance higher.

The stock market’s price-to-earnings ratio, one of the key metrics used by investors to gauge if the stock market is cheap or pricey, has climbed to its highest level in more than five years.

The broad market, as measured by the Standard & Poor’s 500-stock index, is now trading at around 18 times its earnings over the past 12 months. That’s well above the long-term average of 16, according to Bank of America Merrill Lynch. It’s also a richer valuation than the P-E at the market top in 2007.

 

Still, the market’s current state of overvaluation pales in comparison to the sky-high multiple of nearly 30 times earnings back in mid-1999 during the tech-stock mania and eventual run-up to the 2000 market peak, according to data from S&P Dow Jones Indices.

And while valuations are not at nosebleed levels, and are no longer cheap, they are becoming a headwind for the U.S. stock market.

“U.S. stocks remain expensive by historical standards,” Jack Ablin, chief investment officer at BMO Private Bank, noted in a client report. Elevated P-Es, he added, are “one of the biggest impediments to future gains this year.”

The S&P 500 rose 0.9% Wednesday to close at 2123.48, just a third of a percentage point below its May 21 record close of 2130.82. In pre-market trading today the index was down 0.2%.

But high valuations holding back the stock market is a lot different than fomenting a major decline in stock prices, like the burst bubble back in early 2000.

After pointing out that the S&P 500 is trading near all-time highs — at a time when P-Es are also at a post-crisis high — David Bianco, a strategist at Deutsche Bank, says the combination of above-average P-Es, interest-rate uncertainty, weak profit growth and continued soft economic data, boosts the odds of a market pullback this summer. But not a full-fledged correction of 10% or a bear market, or plunge of 20% or more.

“The risk of a near-term 5%-plus dip is high,” Bianco noted, adding that the market this year hasn’t suffered a 5% “pullback,” something that typically occurs once a year.

Currently, investors willingness to pay up for stocks is due to still-low interest rates, Bianco said. Possible market selloff triggers, he says, include a sharp spike in the yield on the 10-year Treasury note, the lack of an economic rebound and a resurgence in the value of the U.S. dollar, which will hurt sales and earnings of U.S. multinationals and push oil prices higher.

The silver lining to the bearish P-E story? The fact that valuation is a “terrible market timer” tool, BofA Merrill Lynch equity and quantitative strategist Savita Subramanian told clients in a research note.

“Valuation,” she says, “explains very little about the variability of stock market returns.” Investors that purchased stocks at similar valuations in the past, she explained, would have seen gains in the next 12 months ranging from 5% to 35%. However, higher P-Es often mean smaller gains going forward, with the S&P 500 posting median gains of roughly 8% a year later — compared to the long-term average of 10% — when investors bought at P-E levels similar to today’s.

Stocks also have better long-term upside potential than alternative investments, such as bonds and cash, Subramanian noted.

“Stocks appear well positioned to offer the best returns of the bunch,” she wrote.

The valuation picture could also improve later this year if the hoped-for earnings rebound comes to fruition, as it will bolster the “E” — or earnings — part of the P-E ratio, adds Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

Investors should also remember that stocks kept going up for years in the mid- to late-1990s despite experts warning of stretched valuations and a brewing stock market bubble. Stocks didn’t peak until four years after ex-Federal Reserve chair Alan Greenspan’s famous warning of investors becoming “irrationally exuberant.”

 

 

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