MARKET VULNERABLE TO TURBULENCE

But stocks seen having more support than last year due largely to lower bond yields, more dovish Fed outlook

STOCK valuations have climbed to levels reached just before Wall Street’s plunge late last year, leaving the market at risk of shocks such as the sell-off last week as global trade tensions mounted.

But stocks may have more support than last year, due largely to lower bond yields and a more dovish outlook on interest rates from the Federal Reserve.

Under the traditional price-toearnings (P/E) ratio method of valuing equities, stocks have risen to their most expensive level since September last year.

The S&P 500 index peaked on September 20 last year, before sliding nearly 20 per cent over the next three months.

The forward P/E for the index, which compares stock prices to estimated earnings over the next

year, had climbed recently to 17 times, making the index about 13 per cent more expensive than its historic average, according to more than 30 years of data tracked by Refinitiv.

After the S&P 500 hit record highs the week before last, United States President Donald Trump had spooked investors by threatening and then raising tariffs on Chinese imports over the weekend.

This ratcheted up tensions in the long-running trade dispute between the world’s two largest economies.

Investors who were optimistic about a US-China deal now worried that such a deal might not happen anytime soon.

The S&P fell last Friday but finished slightly higher after remarks from Trump and other officials fed hopes that Washington and Beijing would avoid the worst-case scenario of a complete breakdown in negotiations.

As of Friday’s close, the S&P 500 was 2.2 per cent below its alltime high close, which in turn reduced the forward P/E multiple on the S&P 500 to nearly 16.8 times, still well above the historic average of 15.1 times.

Last Friday, the S&P 500 rose 0.4 per cent.

“The margin of error is thin based on the reaction we have seen to some of the rhetoric from the US-China trade agreement,” said Michael Arone, chief investment strategist for State Street Global Advisors.

Debate about valuations has taken hold broadly.

Just last week, the Fed called stock prices “elevated” in its latest financial stability report.

Stocks may have a cushion with lower interest rates, which help the allure of stocks.

The yield on the benchmark 10year US Treasury note sits at 2.46 per cent, after eclipsing 3.2 per cent in November, making bonds look less competitive as an investment versus equities.

Stocks are typically valued through by estimating their future cash flows, which are more valuable at lower rates.

The Fed, meanwhile, signalled little appetite to adjust rates any time soon. As recently as December, the Fed anticipated further increases in borrowing costs this year.

Even with last week’s pullback, the S&P 500 is up 22.6 per cent since December 24, when the index posted its lowest close since April 2017.

But earnings estimates for the next 12-month period have only climbed 1.5 per cent over that time, according to Refinitiv data.

So the market’s surge was almost entirely due to valuations expanding, after the P/E fell as low as 13.9 times on December 24.

That imbalance leads some market watchers to say that any significant leg higher for stocks rests on the earnings picture improving, as opposed to valuations going even higher.

As it stands, earnings growth is expected to pick up later in the year, with fourth-quarter S&P 500 profits seen rising 8.1 per cent after increases of between 1.2 per cent and 1.8 per cent in the first three quarters, according to Refinitiv.

Annual earnings are expected to rise 11.7 per cent next year compared with this year.

But a collapse of US-China trade discussions could darken the earnings outlook.

Investors expect tariffs could increase corporate costs and lower profit margins, while persistent uncertainty surrounding a trade deal would hinder the ability of companies to plan, or make capital expenditures.