Via ConvergEx's Nicholas Colas,
Valuation won’t ever tell you if a stock is heading higher or lower. Valuation is math, and math is not an investment edge; it is only helpful because it tells you what the market believes. Figure out why that’s wrong (and it generally is), and now you have something useful. Take the companies of the Dow Jones Industrial Average. On average, they trade for 18.6x 2017 consensus earnings, and 16.6x next year’s estimates. Built into those numbers is expected earnings growth of 11% from 2017 to 2018.
Since corporate earnings have been relatively stagnant for the last 3 years, that’s the first hurdle to jump. Beyond that, you need a point of view on how much better/worse things will be. The best case scenario (every Dow stock earns what the most optimistic Street analyst thinks they can earn) leaves us with US equities trading at 14.8x next year. That is clearly cheap. And if every Dow stock earns only what the most pessimistic analyst has in their model? Then US stocks trade for 18.6x next year. With US rates as low as they are, that is expensive but not horribly so.
Bottom line: if you believe that some parts of the “Trump agenda” will pass at any point this year, the upside earnings case is correct (if not low). And if you don’t, sell. Now.
“There are two times in a man’s life when he should not speculate; when he can afford it, and when he can’t.” Mark Twain
“The wages of sin are death, but by the time taxes are taken out, it’s just sort of a tired feeling.” Paula Poundstone
“Dogs have no money. They’re broke their entirely lives. You know why dogs have no money? No pockets.” Jerry Seinfeld
No reason for those quotes, aside from a little levity. Last week was a long week, with the post-Trump speech rally, the market suddenly realizing the Fed may be serious about raising rates this month, and today’s Snap IPO all making for a busy time. And it’s not quite over yet. Fed Chair Yellen has a speech to the Executives’ Club of Chicago at 1pm on Friday afternoon.
Therefore we’ll keep this note brief and simply address one question: “Are US stocks too expensive to either buy or continue to own?” No, it’s not an easy question. And its only truthful answer is, sadly, another question.
“What do you believe?” Since asset prices reflect the market’s baseline investment scenario, valuation analysis is really the business of measuring how different you are from the herd that sets those prices. Simply doing a Price-Earnings ratio isn’t much of an investment edge. Everyone has access to a calculator. But by knowing the market’s expectations for financial results and operating metrics, you can place your beliefs in sharp relief with the market’s perspective. When your expectations are markedly different from those that other investors believe, you’ve got yourself an investment case.
Let’s take a simple example – the companies of the Dow Jones Industrial Average. The 30 companies of the Dow have scores of Wall Street analysts following them, each publishing an earnings model with estimates for 2017 and 2018 earnings. Some are higher than average, and some are lower. Typically, investors assume that the most likely outcome is close to the average, plus a few pennies (companies tend to beat the consensus by a few percentage points).
Based on the consensus numbers, here’s the current valuation for the Dow:
- On average, analysts expect the 30 companies of the Dow to grow earnings by 11% from 2017 to 2018.
- Mean valuation multiples for the Dow companies are 18.6x 2017 earnings estimates and 16.6x next year.
- On balance, analysts expect that every Dow company will grow their earnings per share in 2018 versus this year. The range here goes from 3% (IBM and Verizon) to 16/18% (Visa and ExxonMobil) to 32-42% (Chevron and Caterpillar).
- Based on this data, most investors would say that US stocks are “Fairly valued” on this year’s almost-19x multiple. The more charitable ones might say “If you can wait until the end of this year, you might see stocks trend higher because that 16.6x multiple on 2018 is still cheap.”
Now, here’s the trick to this analysis: it’s wrong. It is either:
- Too high because analysts always start out too high and bring their numbers down as the year progresses.
- Or too low because despite a very obvious equity rally on expectations for lower corporate taxes and infrastructure investment, not one analyst we know has yet raised their numbers to reflect that fact.
We went through and pulled not just the consensus earnings numbers for the Dow names, but also the highest and lowest numbers any analyst is willing to put in print. That analysis is below.
The upshot of this analysis is the following:
- If every best-case-scenario estimate is correct, the Dow trades for 17.3x this year’s earnings per share and 14.8x next year. Instead of 11% earnings growth, these numbers work out to 16% growth.
- If the worst case scenario is correct, those multiple are 19.7x and 18.6x for 2017/2018 numbers, respectively. Average Dow company earnings growth in this scenario is just 6%.
- Remember: best case scenario estimates still include little-to-no adjustments for lower tax rates from a Trump economic plan.
- While admitted a crude measure, PE ratios of 17x/14x for the bull case look cheap and 20x/19x for the bear case are clearly too expensive for 6% earnings growth in a rising rate environment. (Remember those 3 rates increases we’re baking into asset prices for the year?)
My takeaway: this valuation work shows two things:
- You have to believe there will be some change in US fiscal policy to continue to own equities. Stocks are too expensive otherwise. Now, it doesn’t have to be the Trump Trifecta of lower personal/corporate taxes, deregulation and infrastructure. Any two of the three in sufficient scale probably gets us more than 11% earnings growth next year. Frankly, changes to the tax code alone probably get us there if corporations end up paying 20% instead of 35% of pretax profits.
- Everything else has to go right. Remember that corporate profit margins are higher than long run averages, unemployment is relatively low, and long term interest rates are still below 2.5% on the 10 year US Treasury. At current valuations we can’t afford to lose any of those natural tailwinds to economic growth and corporate earnings.
It could well be that US investors are taking to heart the words of Oscar Wilde: “Anyone who lives within their means suffers from a lack of imagination.” US stock markets clearly do not have that problem at the moment.
via http://ift.tt/2lUNMbN Tyler Durden