Why the stock market has gotten so expensive: Morning Brief

Monday June 22, 2020
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High ratings appear justified, but be careful of the placeholders
At the close on Friday, the S & P 500 (^ GSPC) rose 41% from the March 23 low.
The price rally and the drop in profit forecasts increased the 12-month P / E ratio of S&P to 21.9, according to FactSet. This widespread valuation metric is now well above the five-year average of 16.9 and the ten-year average of 15.2.
While this may seem scary, Wall Street's top strategists see a lot of explanations for what's happening. However, they also warn that the risks for equity investors appear to be downward.
Equity market valuations have risen as prices rise and profit expectations fall. (Factset)
Here's a look at what the professionals are chatting about:
The latest economic data has been surprisingly strong: key metrics such as retail sales and pay slips have grown far more than any economist would have expected in the past month. This suggests that the economy is in better shape than previously thought, at least in the short term. "[E] conomies have reopened, and economic activity measures have moved from the fastest measured decline in history to their fastest growth rate," wrote Steve Wieting of Citi Private Bank on Friday.
Regarding retail sales, Jonathan Golub of Credit Suisse said, "Over the past three months, we have all learned that spending a lot of money when you can't leave the house is difficult, as reflected in an annual decline in personal spending by $ 9.0,000. The result is an increase in personal savings from $ 4.2,000 to $ 18.6,000. While part of it is being banked, previously quarantined consumers appear to be ready to reopen their wallets. "
Ps Lead Es: In the early phase of the market sell-off, we warned Morning Brief readers that earnings revisions (E) lag behind stock prices (P). While the P / E ratio appeared to be declining at this point, there was no reason other than that the “E” was not revised lower as the analysts had not yet adjusted to a recessive economic environment.
But now the opposite can happen. Wall Street strategists are now modeling revised estimates by their colleagues in the Department of Economic Research. An increase in Ps means an increase in P / Es for a short time.
"This type of relative behavior between P / Es and EPS is also typical of cycle bottoms," wrote Francois Trahan of UBS on Thursday. "P / It usually recovers first, and shortly afterwards the profits follow - which is usually a signal that the recovery is indeed sustainable and stocks have a better future ahead of them."
Valuations rise when stocks lead to profits. (UBS)
History suggests that E will rise: As my colleague Myles Udland wrote on Thursday, corporate profits have almost always recovered in a V-shape. Read more here.
Interest rates are low: As we have written several times, low interest rates seem to justify higher valuations in the stock markets.
"The share multipliers rose dramatically from 16.6x today to 21.7x last year," wrote Golub of Credit Suisse on Friday. “At the same time, the yields on 10-year government and investment-grade corporate bonds fell from 2.1% to 0.7% and from 4.5% to 3.6%. Not surprisingly, investors believe current, higher stock valuations are justified given the fall in interest rates. "
Distorted by big tech: Broad market indices like the S & P 500 have risen due to the striking increases in massive tech stocks such as Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Microsoft (MSFT) driven about 20% to 40% since the beginning of the year. Tech-heavy Nasdaq rose 10% this year (^ IXIC), while S&P and Dow are in the red.
"The resilience of the technology sector can be seen in the relative outperformance of the Nasdaq Composite Index (around 40% technology and technology-related stocks) so far this year," wrote John Stoltzfus von Oppenheimer on Friday. Tech stocks generally have better earnings growth prospects and therefore higher P / E ratios.
Beware of the wildcards: however you see it, the market seems to be pricing in lots of current good news and the prospect of a real recovery in the future. And that, in turn, is at your own risk, as there are still many serious unanswered questions.
In a message to customers on Friday, JPMorgan's John Normand identified six “wildcards” that look like “potential spoilers”: a significant second wave of COVID-19 cases; the expiry of temporary fiscal stimulus measures; the end of economic stimulus measures; US sanctions against China "before November to improve Trump's rating or after November when Trump is re-elected"; a US election result that leads to corporate tax increases; and a tough Brexit.
While it is entirely possible to argue that the stock market is not overvalued, the downside risks are considerable.
"This potential valuation problem makes the role of wildcards more relevant," Normand wrote. "Perhaps the sources of downside risk in H2 appear to be more common than the sources of upside risk in recent months due to strong market dynamics."
The billionaire Howard Marks agrees.
"[I] t seems to me that the potential for further profits from things that are better than expected or that valuations continue to rise does not fully offset the risk of a decline due to disappointing events or multiple contractions," Marks wrote in a memo Thursday .
"In other words, the fundamental outlook may be positive overall, but with listed security prices where they are, the opportunities are not in favor of investors."
By Sam Ro, Managing Editor. Follow him at @SamRo
What to see today
economy
8:30 AM ET: Chicago Fed National Activity Index, May (-16.74 in April)
10 am ET: Existing home sales, May (4.09 million expected, 4.33 million in April); Existing home sales month-on-month, May (-5.6% expected, -17.8% in April)
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