Yield spreads versus bonds indicate that stock valuations have considerable upside.
by Milton Ezrati, Senior Economist and Chief Market Strategist, Lord Abbett
Though U.S. equities have done well during the past year and so far this year, still-attractive valuations offer room for this welcome trend to potentially continue in 2013, even though earnings will likely grow slowly.
Earlier in this recovery, when earnings were growing very strongly, consensus concerns about equities cited the danger of an earnings slowdown. Those expressing this concern pointed out, quite rightly, that such a slowdown would occur inevitably as the recovery matured, especially with economic growth proceeding at such a subpar rate. They worried about how the market would react. Many still do. What seems to have escaped notice is that the slowdown already occurred in 2012 and that the stock market offered good returns despite it.
The prospect of slowed earnings growth seemed fearful enough while earnings grew robustly. Anything would have seemed threateningly slow compared with 2009's reported earnings growth in excess of 200%. A slowdown still looked foreboding in 2010, when reported earnings for the stocks in the S&P 500® Index1 rose more than 50% and operating earnings leaped almost 40%.2 A faltering in the pace of earnings growth looked similarly dangerous in 2011, when operating earnings rose near 15%. But when the pace of earnings growth came down to earth in 2012, as per the consensus concern, and grew, accordingly, to best estimates of slightly more than 6%, stock prices were far from shaken. On the contrary, the stocks in the S&P 500 turned in a robust 16% total return for the year. Clearly, the anticipated shock of the dreaded earnings slowdown was much less pronounced than was feared. It was, in fact, nonexistent.
Looking into 2013, slow earnings growth is still a prospect. With real gross domestic product (GDP) likely to expand only 2% or so and inflation likely to run around 2-2.5%, nominal revenues from domestic sources should grow 4.5-5% at best. Overseas exposure, in the emerging economies more than Japan or Europe, both of which are in recession, should add marginally to this top-line growth, bringing it up to about 6%. Meanwhile, profit margins, having risen to about 10% earlier in the recovery and having held there during the past couple of years,3 should at worst hold and could expand. They have, after all, been higher, and approached 11% in 2007. With industry in this country operating at historically low rates of capacity utilization, at about 78.4% of the existing total,4 business would seem to have ample operating leverage to bring margins up another notch. But even without grasping at such potentials, the more conservative expectation of flat margins still suggests earnings growth about in line with revenues at 6% or so.
At the very least, equity prices should track that earnings growth in 2013. With existing dividend yields in excess of 2%, such price gains should generate an attractive total equity return of 8% or so for the year. The odds favor at least this much. Otherwise, matters favor a rise in price-to-earnings [P/E] multiples5 that would generate still better returns. For one, there is little chance that rising interest rates and bond yields will produce ill effects, especially over the next 12 months. The Federal Reserve has, after all, all but promised that. For another, current multiples on 2012 operating earnings, at about 14 times, are still well below multiples of close to 16 times averaged during the last 20 years. If P/E ratios were to climb just half way back to that 20-year average, the market would generate returns in excess of 20%—and even then, valuations would not look especially extended.
Nevertheless, in the unlikely event that bond yields were to rise appreciably, the effect on stocks would likely be muted. Dividend and earnings yields on stocks are relatively so high, from an historical perspective, that a jump in bond yields would more likely adjust the relationship back toward historical norms than affect stock prices. Chart 1, which exhibits just one of an array of stock-bond yield-spread metrics, shows (as all such charts do) how remarkable it is that current circumstances favor equities. Especially since a rise in bond yields would almost surely signal improved economic conditions and, by implication, improved earnings prospects, multiples could rise even in the face of what otherwise would tend to hold them back. In short, the extremes to which stock-bond yield spreads have gone, however measured, suggest that stock valuations have considerable upside, even with rising bond yields and, especially, if the changed rate environment reflects a substantive relief from the many concerns that have brought relative stock valuations to their present, historically low levels.
Chart 1. Stock/Bond Yield Spread, 1987-2012
Source: FactSet. Data from January 31, 1987, through December 31, 2012. The chart is for illustrative purposes only. Past performance does not guarantee future results.
Stocks are represented by the S&P 500 Index. Bonds are represented by the BofA Merrill Lynch 10 Plus Year Corporate Bond Index. Indexes are unmanaged and are not available for direct investment.
But even maintaining an agnostic skepticism about these upside potentials, in profit margins and in multiples, and even staying with the most conservative interpretation of probabilities, prospects still point to a respectable 8%-plus total return from equities.6 Of course, anything can happen. An unraveling in Washington or Europe or more severe trouble in the Middle East, just to choose three sources of concern, could derail further market progress. But on the reasonable assumption that such problems, even as they persist, will spare investors any serious deterioration of their assets, earnings prospects and still-attractive valuations make equities look like a good choice for 2013.
1 The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
2 All data from Standard & Poor's.
3 Profit margins data from Standard & Poor's.
4 Capitalization data from the Federal Reserve.
5 The price-to-earnings [P/E] ratio is an equity valuation measure defined as market price per share divided by annual earnings per share. All data from Standard & Poor's.
6 Data are from FactSet.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
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