High US stock valuations hinge on inflation, interest rates
NEW YORK: Investors are banking on tame inflation and interest rates to support US stock prices and help counter any concerns over an anticipated slowdown in corporate earnings growth next year.
As they have recently, stocks in general are poised to trade at valuations, based on price-toearnings (PE) ratios, higher than they have traded on average since the mid-1980s, investors said.
Yields on US government securities and consumer prices overall have been moving higher, although they remain relatively moderate. Investors said low bond yields mean reduced investment competition for stocks, and relatively subdued inflation supports low interest rates.
“There’s an argument historically with that type of inflation backdrop and rates where they are, that you can justify a higher valuation,” said Walter Todd, chief investment officer at Greenwood Capital in Greenwood, South Carolina.
The ability of stocks to hold relatively high valuations is important because an expected slowdown in corporate profit growth in 2019 could otherwise temper stock returns. Analysts will increasingly focus on next year’s outlook as third- quarter reports arrive next month.
Spurred by corporate tax cuts that took effect this year, earnings of companies on the benchmark S& P 500 index are expected to climb 23 per cent in 2018, and then 10 per cent in 2019, according to Thomson Reuters.
Stocks are commonly valued by their forward PE ratios, meaning their prices divided by earnings estimates for the next 12 months.
The S& P 500’s average forward PE over the past 33 years has been 15 times earnings estimates, but the index has traded above that level for more than two years, according to Thomson Reuters Datastream.
This year, the index peaked at about 18.5 times in late January before the market’s 10 per cent correction, and now trades at about 16.8 times.
More than 60 years of data show that the S& P 500 trades on average at higher valuations when the consumer price index (CPI), a common measure of inflation, is rising annually between zero to four per cent, compared to when it is higher or when there is deflation, according to Keith Lerner, chief market strategist with SunTrust Advisory Services in Atlanta.
Annual CPI last topped four per cent about 10 years ago.
When the CPI increases zero to two per cent, the index trades at 16.6 times forward PE. At two to four per cent CPI growth, the average is 16.4 times. In the 12 months through August, the CPI increased 2.7 per cent, according to data on Thursday.
Lerner calls a PE of 16 to 17 times a fair current valuation, with global trade tensions and other issues causing fluctuations within that range.
“The way the market is looking at this is a 16 level on a forward PE basis is pretty good support,” Lerner said.
Equity strategists at Credit Suisse project the forward PE will drift higher and end 2019 at 18 times. They project the S& P 500 will finish next year at 3,350, a roughly 15 per cent rise from current levels.
Credit Suisse equity strategist Patrick Palfrey said tax cuts and other factors are propping up results in 2018, so next year’s decline in earnings growth is less severe that it seems. — Reuters