On the verge of Donald Trump’s address to Congress, investors have sent the benchmark S&P 500 to record highs. Money managers awaiting word from the new US president on how he will accelerate growth are looking for a reason to maintain their enthusiasm, and for good reason — by a variety of metrics, US share prices are in rare territory.
Here are five charts that make bulls skittish and give bears hope.
The forward price-to-earnings ratio on the S&P 500, one of the classic metrics investors use to value shares, has climbed to 17.7, the highest level since 2004 and above the indicator’s 20-year average. The climb indicates that multiples are once again expanding after a relative rangebound 2016 — before the US election in November.
Viewed slightly differently, the price to trailing earnings ratio for the S&P 500 has climbed to 19.6, which corresponds to subsequent annual returns of 5.9 per cent on average, according to strategists with Citi.
“From a valuation perspective, the US stock market is looking more expensive,” said David Kelly, a strategist with JPMorgan Asset Management. “Moreover, the forward earnings estimate upon which [the price-to-earnings ratio] is based is a lofty 24 per cent higher than the actual operating earnings per share achieved by S&P 500 companies last year.”
Adjusted measures of price to earnings, including a popular metric developed by Yale University professor Robert Shiller, also show investors paying relatively high valuations for a piece of the S&P 500. The so-called CAPE measure — or cyclically adjusted price-to-earnings ratio — adjusts for inflation and utilises a trailing moving average of the last 10 years’ worth of earnings. It, too, is flashing that stocks look rich.
A missing ingredient in much of the recovery has been strong sales growth, a point that cannot be glossed over with stock buybacks. Investors are now paying the most for each dollar S&P 500 companies generate in sales since 2000, according to Bloomberg. Analysts with Jefferies note that the number of groups lifting revenue forecasts for 2017 has been “modest”.
Another valuation flashing red for US equities is known as Tobin’s q, a measure of the market value of all US companies divided by the value of those same companies’ assets. In other words, is the whole worth more than the sum of the parts? The metric, established by Nobel laureate James Tobin and based on quarterly data from the Federal Reserve, has averaged about 0.7 over its history. At the end of the third quarter it sat at 0.97 — or 39 per cent above that average.
Investors looking for an update from this metric need only wait until the end of next week, when the Fed is expected to provide updated figures through the end of last year.
The dividend yield on the S&P 500 as a ratio of the 10-year US Treasury is showing that stocks look much less risky than they did ahead of the US election. Why? Before the election, when the outlook for interest rate increases was less clear, bond yields remained low while dividend stocks were in high demand. A reversal has since ensued amid expectations that Mr Trump’s policies will boost economic growth. That has curtailed interest in dividend-paying stocks in favour of cyclical ones.
“The market rally appears to incorporate a positive earnings impact from as yet loosely defined Trump fiscal policy plans,” said Alan Gayle, director of asset allocation at RidgeWorth Investments. “Unless we see a significant set of fiscal policy initiatives that can get either broad Republican support or can cobble together votes from moderate Democrats, risks of a near-term correction have increased.”
On the chart below, a ratio above 1 indicates that the dividend yield on the S&P 500 is higher than the yield on the 10-year Treasury, a point market bulls have often turned to to explain their view that stock market valuations are not as stretched as they may appear.
For investors looking for a strong reason to buy US stocks now, money managers can take solace in at least one archaic metric: the price of the S&P 500 divided by the price of gold. On this basis, the S&P 500 is trading at just twice the price of the yellow metal — a level surpassed throughout much of the 1960s and at the turn of the century.
