Stocks have been in rally mode with the prospects of fiscal policy aimed at generating stronger and more consistent U.S. economic growth, especially corporate tax cuts. This rally comes as corporate earnings are trying to recover from a contraction phases started over two years ago. Earnings have improved in Q4 but there’s worry stocks are overvalued. A better understanding of what is driving current valuations may reduce anxiety for those investors looking to put new money to work.
Before we dig into current factors driving stock market valuations it is important to recognize the S&P 500 P/E ratio has spent consecutive years at levels considerably higher than they are today, as illustrated in the graph below. Stocks have only just become slightly more expensive than their 20-year average. The influence during the late 90’s is significant but it is reasonable to believe this is the current value range for the U.S stock market and we could test much higher levels before a decline.
The current P/E for the S&P 500 is 17.6 based on estimated operating earnings. This is the highest the ratio has been since 2004 as reported by the Wall Street Journal. For a better understanding of the current environment we need to look at what’s driving today’s valuation. Let’s begin with the price of oil and its impact on earnings from the energy sector.
Economist have been plagued by wild swings in the price oil price over the last couple of years. Companies in the energy sector have been hit particularly hard, driving down their earnings. This has pushed the energy sector P/E ratio up to around 30. If you exclude the energy sector from S&P 500 earnings it falls to a more palatable 16.6. Indeed, an earnings recovery from energy companies should help bring the S&P 500 P/E ratio down.
Interest rates are another important factor in the current environment driving valuations for the stock market. Low rates tend to drive valuations higher because future earnings are worth more when discounted back into today’s dollars. Said another way, the present value of future earnings are higher when interest rates are low. Cheap debt has also boosted profit margins and there is reason to believe this will continue. The Fed may have started the process of raising rates but they still trail the rate of inflation. There is likely a cap on how high rates will go because of the costs imposed on the federal budget to refinanced and service new debt.
Low interest rates have pushed every sector of the S&P 500 to elevated levels but nothing extraordinary. As the chart above illustrates, it may be premature to act as though this market is too expensive for stocks to continue to advance. The most expensive sector after energy is Consumer Staples, hardly what you would expect from an overheating market.
Right now investors expect oil prices to stabilize leading to improved energy sector profits. In terms of interest rates, inflation is expected to remain subdued providing cover for slow rate hikes by the Fed. Investors shouldn’t be surprised if this market continues to advance for a considerable period if those factors follow their expected paths while the Trump administration works on implementing their fiscal stimulus plans.
