Against most expectations, U.S. stocks are turning in a respectable performance this year. The S&P 500 is now up 7% year-to-date, recovering from what would charitably be described as a shaky start to the year (source: Bloomberg).
That’s the good news. The bad news is that the gains, which are coming against the backdrop of a prolonged earnings recession, have been entirely driven on multiple expansion. In other words, investors are willing to pay more per dollar of earnings. From the lows earlier this year, the trailing multiple on the S&P 500 has risen by roughly 22% (source: Bloomberg).
The rapid ascent in the market multiple has left stocks expensive. The S&P 500 is now trading at 20.5x trailing price-to-earnings (P/E), well above the historical average of 16.5x, according to Bloomberg data. While investors can partially justify this on the basis of a lower discount rate, i.e. low interest rates, it is worth highlighting that even in the context of low rates, valuations are elevated. Yields have been consistently low, averaging 3.25% for the 10-year Treasury bond, since 2003 (source: Bloomberg). Yet, during this same period valuations have still only averaged 17x trailing earnings.
Look for faster earnings and economic growth
If stocks are to advance further, sustainable gains need to be predicated on faster earnings growth. That, in turn, is a function of nominal GDP (NGDP), real growth plus inflation. Looking back over the past 60 years, the level of NGDP has been strongly correlated with non-financial profit growth. During this period NGDP growth has explained roughly 20% of the variation in profit growth.
The relationship is not hard to understand. While individual companies can take market share from rivals, that can’t sustain growth across the broader market. At the aggregate market level, faster economic growth is necessary to drive faster revenue growth. Although it is true that international sales have grown for most large-cap companies, making the U.S. dollar another critical variable, nominal domestic economic growth is still the primary driver of corporate earnings.
One can argue that markets can advance as valuations press higher, even in the absence of faster growth. For example, the chart below shows the trailing P/E on the S&P 500 pushing above 20 in the spring of 1997, and investors who remained in the market enjoyed another three years of spectacular gains. Of course, the tech bubble ultimately ended badly.
That was then, this is now
Unfortunately, the factors that fueled the latter part of the 90s bubble are not likely to be repeated. From the spring of 1997 until the end of 1998, yields on both the 2- and 10-year Treasury notes fell roughly 200 basis points (2%), while inflation continued its multi-year decline. At the same time, growth surged on the back of stellar productivity. Today, productivity is at multi-year lows, demographics are working against growth and any further drop in inflation or rates would likely come in the context of deflation, not a supportive environment for stocks.
The best hope for the market lies in faster growth. In the absence of faster NGDP, investors are making a different bet: that a combination of paltry bond yields, buybacks and elevated margins make equities the “least bad” bet. That is not a gamble that is likely to end well.
Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.