Financial markets 2018: P/E ratios are great again
Professor of Finance, Kelley School of Business, Indiana University
James and Virginia Cozad Professor of Finance, Kelley School of Business, Indiana University Bloomington
The most remarkable development over the last year is the disappearance of volatility in the financial markets. The most-followed measure of stock market volatility is called the VIX, which is a technical combination of option prices.
It was created in 1993 and it represents the market’s forecast of volatility over the next 30 days. It has been at its lowest levels in its history throughout 2017. The steady decline of the VIX started just after the election last year. Investors appear not to care about the difficulty that Republicans have passing major legislation, not to mention the turmoil in the White House.
Last year, we commented on how the market seemed to be discounting the campaign rhetoric. We speculated that the market treated both campaigns as if they were sales pitches that neither candidate believed or really thought they could implement. We thought we were an outlier in this view. We were not. The drivers of the stock market appear to be solely earnings forecasts and valuation ratios. Certainly, the lightly covered economic news of deregulation in almost every sector helps boost returns, as does the talk of a tax cut. But until we get a tax cut or any major legislation, Washington news appears more irrelevant than ever to the financial markets.
On the other hand, we were thankfully wrong in our forecast that the stock market returns would be below their long-run average return. Between October 30, 2016 and October 30, 2017, the S&P 500 index increased about 21 percent. This is far above the long-term average of about 7.5 percent and in line with the memorably high returns in 2012-2014. It certainly is quite an improvement over the low returns in 2015-2016. The returns to the Nasdaq Composite and Dow Jones indices were even better, coming in at 29 percent and 31 percent, respectively.
We certainly believe that the agendas that appeal to the base supporters of each party, if fully implemented, would not be good for the stock market. The unlikely Democratic agenda of higher taxes and regulation to ostensibly help the middle class will discourage business investment and startups. The somewhat more likely, Steve Bannon–promoted, Trump agenda of sharp restrictions on trade and immigration will likely hurt much more than a tax decrease will help—especially if it sparks a trade war—but the threat at this point seems unlikely.
We don’t see the growing deficit causing dramatic movement in the bond market. With the economy jogging along at an even pace, we think the market is focused on cash flows and valuation—which is what we mean by “P/E ratios are great again.”
What were the important developments in 2017?
Federal Reserve policy: While we were supportive of the Fed’s liquidity policies during the financial crisis, we are concerned that the aggressive monetary policies since 2009 have become counterproductive and pose a material risk to our investment portfolios. We think the Fed’s recent decision to shrink its balance sheet and reduce its bond portfolio is a net positive.
Despite three increases in the federal funds rate over the past 12 months, short-term rates remain low at 1.25 percent. The Federal Reserve recently has kept interest rates flat, a “dovish” policy in targeting interest rates rather than inflation in the near term. We expect a small increase in the federal funds rate in December and then one or two small increases next year. This may cause some volatility in the stock market.
Earnings: From 1980 until 2009, GDP growth averaged 3.2 percent per year; between 2009 and 2016, it fell to about 2 percent per year. This lower growth was reflected in lower corporate earnings, which were about one-half their historical average. This is no doubt a reflection of what has been the weakest post-recession recovery of the modern era. In 2017, however, we saw a reasonably strong rebound with S&P 500 earnings rising about 10 percent.
International trade: The S&P 500 derives about 30 percent of its revenue from sales outside the U.S., making earnings sensitive to growth in the global economy. This was a positive factor for earnings as global GDP rose about 3.5 percent in 2017, up from about 1.4 percent in 2016.
What about 2018?
With this as a background, we turn to fundamentals. Stock prices are determined by the future stream of cash flows—driven by earnings—and the valuation of these cash flows, which is the present value using a discount rate that reflects risk. Typically, this is summarized by earning forecasts and a valuation measure, such as the price-earnings (P/E) ratio.
The positive fundamental factors for stock returns in 2018 are:
- Earnings growth: Analysts are forecasting earnings will increase about 11 percent in 2018 for the S&P 500. Energy is predicted to grow 35.1 percent. Telecom services is expected to be the worst sector with a 1.3 percent growth.
- Revenue growth: Among S&P 500 firms, revenues are expected to rise 5.2 percent in 2018. The best sector, information technology, is expected to rise 9.3 percent, while the worst sector, telecom, is predicted to rise 0.6 percent.
- Year-over-year earnings growth: This is a positive 4.7 percent growth for the S&P 500 between the third quarters of 2016 and 2017, but it would jump to 7.4 percent without the insurance industry, which reported the largest percentage decline of all industries (-66 percent), due to the recent hurricanes and the earthquake in Mexico.
- Year-over-year revenue growth: This is a positive 5.7 percent for the S&P 500.
- Quarter 3 earnings and revenue “beats:” Of the companies in the S&P 500 that have reported earnings and revenues for the third quarter of 2017, 74 percent have reported earnings above the mean estimate of analysts (higher than the historical average of 69 percent) and 66 percent have reported revenues above the mean estimate (matching the historical average).
- IPOs are strong: There have been 170 IPOs filed in 2017, which is up 60.4 percent from 2016. As of November 2, there have been 129 completed IPOs (which is up 35.7 percent from 2016) and total proceeds raised so far are $31.6 billion, up 89 percent from the prior year. The biggest sector is health care (39 IPOs), followed by technology (26 IPOs) and financials (16 IPOs).
- Eurozone data is positive. The eurozone GDP is seen growing at a relatively buoyant 2.1 percent pace in 2017 "on the back of a healthier labor market, ultra-accommodative monetary policy and stronger global backdrop. Next year, activity is expected to decline somewhat, but still remain healthy, as tailwinds to growth ease."1
- We think inflation will remain subdued. Our forecast of 2 percent is in line with most forecasts (the Fed’s forecast is 1.5 percent, the Office of Management and Budget’s is 2.2 percent, and the Organization for Economic Cooperation and Development’s is 1.9 percent).
However, there are some headwinds:
- Valuation: P/E ratios are above their long-run averages. The S&P 500 P/E ratio is 24, above its long-term average of 15.9. The “forward” P/E (price today divided by expected earnings) is 18, which is also above its long-term (10-year) average of 14.3. The Dow has a P/E of 21.2, which is above its 10-year average of 16.
- The cyclically adjusted P/E ratio (CAPE) for U.S. stocks is at 31.3, which is the highest since mid-2001 and far above its historical average of about 18. If we average seven years of earnings, rather than 10, the CAPE ratio is about 26, which is also far above the long-term average. Earnings will have to grow faster than predicted by analysts to justify the current level of the market.
- Trump administration threatens trade: The Trump administration continues to view international trade as a threat and not a benefit for the U.S. economy. Recent tariffs on Canadian aircraft are a concern as they indicate a willingness to impose higher costs on imports—which is a tax increase.
- Eurozone unemployment is high and Catalan independence threatening.
- Asia forecasts: The World Bank raised its economic growth forecasts for developing East Asian and Pacific countries for this year and 2018, but added the generally positive outlook was clouded by risks, such as rising trade protectionism and geopolitical tensions.
- U.S. debt: The expansion of the national debt since the end of 2008 is unprecedented since World War II. The total debt (held by the public) to GDP ratio has increased to 77.5 percent in 2017. Congressional Budget Office (CBO) projections for 2018 have it unchanged as a percent of GDP under current policies. At least it isn’t rising! Neither the Republicans nor the Democrats have any feasible program to decrease the federal debt, and it probably will expand in the future. The massive government deficits may lead to fears of higher interest rates, accelerating inflation and slower GDP growth in the future.
- Budget deficits: The projected budget deficit for 2017 is about 2.9 percent of GDP. If interest rates return to their historical average levels, the budgetary impact will be dramatic. The average interest rate on debt held by the public is about 2 percent and interest payments are forecast to be $266 billion, and rising to $333 billion in 2018. The interest payments are expected to be 7.7 percent of the federal budget in 2018 and 8.8 percent in 2019. Increasing the average rate by 1 percent will trigger an additional $140 billion in federal spending. This will require reduced spending in other areas, increased taxes or both.
- The U.S. still faces a huge funding deficit in Social Security, Medicare and other programs. According to a CBO estimate from 2013, the total present value shortfall (including debt) of these programs is about $205 trillion. This is equivalent to $631,000 per person or $2.52 million per U.S. household. These problems are not insurmountable, but they do require common sense and bipartisan leadership—something that appears to be in short supply in Washington, D.C.
Looking forward to 2018, the positives outweigh the negatives for the economy. We expect the recovery to continue, GDP growth in the 2-3 percent range, and inflation around 2 percent. The combination of low inflation, a Fed that is cautiously returning rates to normal levels and decent prospects for earnings growth suggest at least a positive year for stocks. The primary risks are trade restrictions from Washington, economic policy uncertainty and the unwinding of the Fed’s bond purchases.
In this environment, we expect the return to equities to be positive but below the 7.5 percent average return over the past 50 years. With Treasury bonds already at extremely low yields, there is little potential for gains with these investments. In addition, we think there are material long-term inflation risks that could make long-term bonds unattractive. Investors should stick to short-term bonds to reduce their exposure to higher interest rates.
- "Euro Area Economic Outlook October 2017, " Focus Economics, September 27, 2017, www.focus-economics.com/regions/euro-area/news/ea-economic-outlook-oct-2017.