Why the stock market has gotten so expensive: Morning Brief

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High valuations appear justified, but beware the ‘wildcards’

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="As of Friday’s market close, the S&amp;P 500 (^GSPC) was up 41% from its March 23 low.” data-reactid=”20″>As of Friday’s market close, the S&P 500 (^GSPC) was up 41% from its March 23 low.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="The rally in stock prices along with declines in earnings forecasts have sent the S&amp;P’s forward 12-month P/E ratio to 21.9, according to FactSet. This widely followed valuation metric is now way above its five-year average of 16.9 and its 10-year average of 15.2.” data-reactid=”21″>The rally in stock prices along with declines in earnings forecasts have sent the S&P’s forward 12-month P/E ratio to 21.9, according to FactSet. This widely followed valuation metric is now way above its five-year average of 16.9 and its 10-year average of 15.2.

While this may seem scary, Wall Street’s top strategists see plenty of explanations for what’s happening. Though they also warn that the risks facing equity investors appear tilted toward the downside.

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Here’s a look at what the pros are chattering about:

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Recent economic data has been surprisingly strong: Key metrics like retail sales and payrolls grew by far more than any economist could have expected last month. This suggests the economy, at least in the short-term, is in better shape than previously thought. “[E]conomies reopened, and with it, economic activity measures have gone from the fastest pace of measured decline in history to their fastest rate of increase,” Citi Private Bank’s Steve Wieting wrote on Friday.” data-reactid=”35″>Recent economic data has been surprisingly strong: Key metrics like retail sales and payrolls grew by far more than any economist could have expected last month. This suggests the economy, at least in the short-term, is in better shape than previously thought. “[E]conomies reopened, and with it, economic activity measures have gone from the fastest pace of measured decline in history to their fastest rate of increase,” Citi Private Bank’s Steve Wieting wrote on Friday.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Regarding retail sales, Credit Suisse’s Jonathan Golub noted: “Over the past three months, we’ve all learned that it is difficult to spend a lot of money when you can’t leave home. This is reflected in the $9.0k decline in personal expenditures, on an annual basis. The result is an increase in personal savings from $4.2k to $18.6k. While some portion of this will be banked, previously-quarantined consumers appear ready to reopen their wallets.”” data-reactid=”36″>Regarding retail sales, Credit Suisse’s Jonathan Golub noted: “Over the past three months, we’ve all learned that it is difficult to spend a lot of money when you can’t leave home. This is reflected in the $9.0k decline in personal expenditures, on an annual basis. The result is an increase in personal savings from $4.2k to $18.6k. While some portion of this will be banked, previously-quarantined consumers appear ready to reopen their wallets.”

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Ps lead Es: During the early phase of the market selloff, we warned Morning Brief readers that earnings (E) revisions lag stock prices (P). And so while P/E ratios seemed to be falling at the time, it was for no other reason than ‘E’ not having yet been revised lower as analysts hadn’t yet adjusted to a recessionary economic environment.” data-reactid=”37″>Ps lead Es: During the early phase of the market selloff, we warned Morning Brief readers that earnings (E) revisions lag stock prices (P). And so while P/E ratios seemed to be falling at the time, it was for no other reason than ‘E’ not having yet been revised lower as analysts hadn’t yet adjusted to a recessionary economic environment.

But the opposite may be happening now. Wall Street strategists are now modeling in revised estimates coming from their colleagues in the economics research department. And so, surging Ps will mean surging P/Es for a short while.

“This kind of relative behavior between P/Es and EPS is also typical around cycle bottoms,” UBS’s Francois Trahan wrote on Thursday. “P/Es tend to recover first, and shortly thereafter earnings follow suit—which is usually a signal that the recovery is indeed sustainable and equities have a brighter future ahead.”

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<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="History suggests E will surge: As my colleague Myles Udland wrote on Thursday, corporate profits have almost always seen V-shaped recoveries. Read more here.” data-reactid=”51″>History suggests E will surge: As my colleague Myles Udland wrote on Thursday, corporate profits have almost always seen V-shaped recoveries. Read more here.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Rates are low: As we’ve written multiple times before, low interest rates appear to justify higher stock market valuations.” data-reactid=”52″>Rates are low: As we’ve written multiple times before, low interest rates appear to justify higher stock market valuations.

“Stock multiples have increased dramatically over the past year from 16.6x to 21.7x today,” Credit Suisse’s Golub wrote on Friday. “At the same time, 10-year Treasury yields and investment grade corporate bond yields have collapsed from 2.1% to 0.7%, and 4.5% to 3.6%. Not surprisingly, investors are making the case that current, elevated stock valuations are justified given the collapse in rates.”

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