John Lynch Chief Investment Strategist, LPL Financial
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Time to check in on stock valuations. After providing our assessment of stock market fundamentals, sentiment, and technical conditions over the past few weeks, this week we turn to the last piece of our investment process: valuations. Here we will make the case that stock valuations are reasonable, despite above-average price-to-earnings (PE) ratios.
VALUATIONS HAVE COME DOWN
Before making the case that stocks are fairly valued, we want to first point out how far valuations have fallen in recent months. Our favorite valuation tool for stocks, the PE ratio, has seen a falling “P” and a rising “E.” The S&P 500 Index is about 7% off its closing high for the year, set on January 26, while estimates for 2018 earnings for the index have risen by about 3% during that time (they are up 8% year to date). The increase in earnings estimates for the next four quarters is even more dramatic, having jumped 6% since the January stock market peak, boosted by very strong first quarter earnings growth of 24% year over year, a big upside surprise compared with estimates as of quarter-end, and mostly positive guidance from company management teams. Higher analysts’ earnings estimates coupled with lower stock prices have clipped about 12% off stock valuations in just the past three months, taking the S&P 500’s forward PE from 18.5 to 16.2, according to FactSet data.
A CASE FOR STOCKS BEING FAIRLY VALUED
We believe the S&P 500 is fairly valued at a forward PE ratio of slightly over 16, even though that level is a touch above the post-1990 average of 15.4. On a trailing PE basis, using earnings over the past four quarters, the PE is higher at 20 (the long-term average is near 17). But in a scenario of sharply rising earnings, trailing PEs tend to be inflated and fall quicker as earnings ramp up—the trailing PEs may fall by a point or two by year-end assuming stock returns and earnings reach our targets (both up double digits). Simply put, we think above-average valuations are justified given our positive outlook for earnings, still-low interest rates by historical standards, and low inflation. We look at each of these factors below.
Forward PE disclaimer
Valuations relative to overly optimistic estimates can be misleading so before evaluating forward PEs, we ask ourselves how likely S&P 500 companies are to produce earnings at or near consensus estimates. While our estimate for 2018 S&P 500 earnings for share, at $152.50, is below the consensus estimates tracked by Thomson Reuters and FactSet of $158–159, implying 20% earnings growth, the strong start to earnings season and the resilience of earnings estimates during earnings season leaves our estimate potentially on the conservative side. Bottom line, we think the earnings outlook is sufficiently strong to justify slightly above-average valuations based on forward earnings estimates.
Still-low interest rates
Interest rate levels, which are another important consideration when evaluating stock valuations, are currently supportive of above-average stock valuations. Interest rates dictate how attractive bonds are relative to stocks, so lower rates make stocks relatively more attractive. Interest rates also determine the discount rate at which future cash flows are discounted back to arrive at a present value (in theory, that’s fair value for the stock market). Interest rates are also indicative of financial conditions. Easier financial conditions are generally supportive of higher valuations.