Jurrien Timmer: A Matter of Valuation

Jurrien Timmer: A Matter of Valuation




MAY 2017

A Question of Valuation

With U.S. stock prices on the high side, keep an eye on earnings and less-expensive opportunities overseas.

by Jurrien Timmer, Director of Global Macro, @TimmerFidelity | Fidelity Investments Canada

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Key Takeaways

• The price-to-earnings (P/E) ratio for the S&P 500® Index has jumped more than two points since the November 2016 U.S. election, driven by expectations of improved earnings growth.
• The P/E increase has occurred despite a rise in bond yields, which normally acts as a valuation headwind for stocks.
• U.S. earnings are growing again, but valua.tions have already priced this in, suggesting that U.S. stock prices could lag behind earn.ings growth as the market waits for earnings to come through before any lift in the multiple.
• Less-expensive opportunities for growth may be found in stock markets outside the U.S.

U.S. stocks moving sideways

Prior to April 24–25, the U.S. stock market had moved sideways in recent weeks, with the large-cap S&P 500 Index down 2% to 3% from its February highs and the small-cap Russell 2000® Index stuck in a sideways pattern since mid-December. I see two reasons for this.

First, the U.S. economy has reached peak reflation, meaning it’s still growing, but at a slower pace (see April commentary “Peak Reflation May Be Looming”). As evidence, global PMIs1 declined last month. After peaking in February, U.S. manufacturing growth slowed to a six-month low in March, and new orders came in at the slowest pace since October.2 History shows that when economic momentum peaks, the stock market tends to be choppy for a while. That doesn’t necessarily mean a correction or bear market, just a stalling out.

The second reason why stocks may be moving sideways is the uncertainty surrounding potential fiscal policy. It’s still unclear if, when, or how fiscal stimulus will be implemented, and we also don’t know what the impact will be on GDP for every dollar spent on fiscal stimulus.

If the stimulus is on the demand side (e.g., infrastructure spending), it could potentially be offset by more- aggressive interest-rate hikes by the Federal Reserve (Fed), which would reduce the GDP benefits while leaving interest rates higher. Not exactly a win-win strategy.

After eight years of economic expansion and with employment relatively full, any demand-side fiscal shock could be inflationary. But if stimulus is on the supply side (e.g., a permanent reduction in taxes and regulation), GDP growth could rise and keep the Fed at bay. GDP growth equals labor force growth plus productivity growth. The labor force is not growing much, so higher GDP will have to come from higher productivity.

Market positive: corporate earnings

With fiscal policy changes likely delayed until later this year, and with the economic growth rate slowing, it’s no surprise the market has stalled a bit. The good news is that corporate earnings are on the rise. The earnings season is in full swing and the expected year-over-year growth rate for Q1 is 9.7%.3 With the usual seasonal drift, Q1 earnings growth could be in the double digits.

That’s a far cry from Q1 2016, when earnings were falling 7% year over year. Granted, comparisons to last year’s trough earnings are easy, but the improvement is real.

Market concern: valuations

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