MOVING UP

Playing multiple choice with multiples.

One of the bigger current debates among market analysts is whether stocks can depend on expanding multiples to move higher.

Equities have pulled back in the past week, owing to uncertainty caused by the U.S. government shutdown, but returns in most global markets have been fairly robust this year.

A big chunk of that growth is because of multiple expansion. Pierre Lapointe, head of global strategy and research at Pavilion Corp., calculates that 68% of the S&P 500’s returns this year can be attributed to expanding multiples.

Essentially, a stock’s multiple is the amount investors are willing to pay for each dollar of a company’s earnings. A common way to calculate this is the price-to-earnings ratio.

The S&P 500’s price-toearnings ratio has recently been floating at a lofty 14.4 times forward earnings, raising questions about whether it has further expansion room. The last time the S&P 500 saw that kind of P/E ratio was in 2010, following a breakneck rally that suddenly reversed with the emergence of the eurozone crisis that May.

Stéfane Marion, c hi e f economist and strategist at National Bank Financial, is, not surprisingly, warning investors that the current situation also looks a little rickety.

“It seems to us that the bottom-up consensus is failing to price in a potential disappointment from the ongoing debt ceiling stalemate,” he said.

Mr. Marion adds that with so much of the rally this year depending on investors’ willingness to pay more for each dollar a company earns, a disappointing earnings season could spell bad news for stocks.

Brian Belski, chief investment strategist at BMO Capital Markets, warns that now is the time for investors to pay more attention to companies that have a chance to beat earnings expectations this season and avoid indextracking products.

“One of our predominant investment themes has been for investors to adopt a more active approach when making investment decisions as opposed to utilizing more passive investment strategies, such as benchmarking or ETFs,” he said.

History has shown that multiples can move up from current levels. The S&P 500’s average P/E ratio in the past three decades is 14.9.

But P/E levels above the average can potentially signal impending pullbacks — or even crashes. The S&P 500’s peak multiple of 25.6 in March of 2000 also marked the start of the dot-com crash.

Other times, however, a multiple expansion has started rallies. Pavilion’s Mr. Lapointe said he recently examined data going back to 1982 to look at how markets performed when multiples significantly contracted or expanded. He found 382 different contraction/expansion events during that time, with 49 specific instances of multiples expanding 10% to 20%, similar to what has happened this year.

The data show that three months after a multiple expansion, the S&P 500 tended to be up by an average of 5.2%. Good returns continued after six months as well, with the average gain being 7.9%. One year after the expansion, returns averaged a whopping 16.3%.

“In fact, a 10%-20% multiple expansion [similar to the one seen this year] is usually a sweet spot that results in some of the highest returns in our analysis,” Mr. Lapointe said.

As the data show, a multiple expansion can signal impending danger, but high multiples don’t necessarily spell doom for investors.