Currently, what is the appropriate valuation of the U.S. stock market? S&P Capital IQ Global Markets Intelligence (GMI) constantly wrestles with this question within the context of the vigor and stability of the economy, future corporate earnings growth expectations, and the relative attractiveness of other asset classes compared with developed market equities.
Although we prefer to reference the 15-year quarterly average forward 12-month price-to-earnings (P/E) ratio as the long-term market valuation benchmark (currently 16x), the truth is that the one-year forward multiple is anything but a stable reference value.
Earlier this year, we believed that the fully valued stock market required an ideal market turn of events and outcome in the second half of this year, which has now come into question due to slowing economic growth abroad--particularly in Asia. Because of these events, we are now pondering if this is the appropriate valuation for the stock market.
In the past 79 years, the 15-year average forward P/E has ranged from a low of 10.1x in 1954-55 after World War II to a high of 20.3 in 2005 following the extreme valuations recorded during the tech stock bubble period.
Between these two extreme periods, the average P/E rose to 16.8 in late 1972 and early 1973 before pulling back to 10.3 in late 1988 and early 1989 following the global stagflation of the 1970s (see chart).
We investigated market valuation developments since the start of this economic recovery cycle in 2009 to discern an appropriate P/E valuation on a near- to intermediate-term basis and found the following:
- The S&P 500 Index was valued at 16.5x forward earnings as the U.S. economy exited the recession at mid-year 2009. The economy and financial system remained fragile, and investor confidence in the macroeconomy remained low, so the forward P/E for the S&P 500 declined further to as low as 12.4x by the second quarter of 2010 when investors had serious double-dip recession anxiety.
- The equity market valuation then rebounded to 14.4x at year-end 2010 as the U.S. economy started to sustain respectable but still preliminary monthly gains in non-farm payrolls.
- The valuation then took a brief but serious hit in the third quarter of 2011, dropping to 11.5x after Standard & Poor's Ratings Services downgraded the U.S. sovereign rating to 'AA+' from 'AAA' in August 2011.
- It then held between 13x and 14x throughout 2012 as the U.S. economy slowly improved, bringing the unemployment rate to 7.9% at year-end 2012 from 8.5% at year-end 2011.
- The Federal Reserve responded to U.S. GDP growth of less than 1% in the second half of 2012 by resorting to a third round of quantitative easing in September 2012. This event ushered in a period of sustained U.S. economic improvement that has helped expand the forward P/E ratio from 13.6x at year-end 2012 to 17.7x during the summer of 2015.
Since the end of July, the S&P 500 Index has pulled back from a forward P/E ratio of 17.1x on July 31 to as low as 15.3x on Aug. 25, according to S&P Capital IQ consensus data. GMI Research does not currently believe that existing healthy U.S. macroeconomic conditions justify a sub-15x forward P/E ratio as was seen at various times between 2010 and 2012 when confidence in the U.S. and global economy was significantly lower than it is today.
We will hold this belief as long as global economic conditions remain free of an exogenous shock or a disruptive domestic event does not occur, such as a prolonged shutdown of the U.S. federal government. While we would consider a recession in China or Europe as sufficiently disruptive, we do not believe that a preliminary interest rate hike by the Federal Reserve will be anything close to an unanticipated shock to the financial system.
Based on these views we believe that the S&P 500, and high-quality global equities, are now a compelling investment opportunity for individuals with an intermediate- to long-term investing horizon. This is certainly true relative to the above average historic valuations seen during the first half of 2015. Having said this, a significantly more complex global economic or Federal Reserve policy outlook could challenge this view and open the door for a test of a 14x-handle for the S&P 500 forward P/E ratio.
GMI Research was not surprised to see that the FOMC refrained from raising interest rates at the September meeting. The Fed’s post-meeting press release disclosed that they are “monitoring developments abroad” to see whether “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”
The GMI Translation: If the Fed is concerned about what is occurring abroad, then so should investors. Fed indecision and the implied uncertainty regarding the global economic outlook will likely continue to elevate financial market volatility in the near-term as witnessed since the start of the final week of August.
Nonetheless, we will likely retain our generally positive view of stocks so long as the global economy continues to expand and consumer price inflation does not become an issue for the Fed. Inflation quickly became problematic for policy makers during the 1970s, leaving Fed Chairman Paul Volcker little option but to purge inflation from the U.S. economy via a drastic tightening of U.S. monetary policy that ultimately drove P/E ratios into single-digit territory. But for the moment, the Fed appears to be more concerned with fighting latent post financial crisis global deflationary pressures than they are with risks of instigating domestic inflation.