Are Stock Markets Still Overvalued?

Economic

Stocks

Summary:

Stock markets have retreated lately, as bond yields stormed higher. But equity valuations are still stretched and earnings growth is stagnant. Sky-high yields and global slowdown could keep markets under pressure.

Stocks drop as yields soar

The phenomenal rally on Wall Street lost some steam in the third quarter, mostly because of the seismic moves in bond markets. Yields on U.S. government bonds have risen to their highest levels since the financial crisis, boosted by bets that interest rates will remain higher for longer and an increase in debt issuance to fund massive government deficits.

When bond yields climb so aggressively, that puts pressure on riskier plays such as stocks. Higher yields essentially attract investors to bonds and reduce speculation in other markets. If investors can buy a safe U.S. government bond that pays a return of 4.75% per year, like they can today, they are less likely to take wild chances in other assets. In theory, that dampens demand for stocks, which are considered riskier investments.

Therefore, the ferocious spike in yields helped spark a correction in equities. However, the correction has not been dramatic. Both the S&P 500 and the tech-heavy Nasdaq have declined 8% from their summer highs, which is a relatively small move considering just how high yields have gone.

Valuations are still excessive

Despite the recent retreat, equity valuations are still stretched by historical standards. The S&P 500 is currently trading at 18 times what analysts project earnings to be over the next twelve months. That's under the assumption that earnings are going to grow 12% next year.

Such a high valuation would make sense if bond yields were extremely low, like most of the past decade. But yields are high and rising. The last time yields were so elevated, back in 2007, the stock market was trading for less than 15 times earnings. And those levels themselves represented a market top as the 2008 financial crisis followed, decimating stock prices. In other words, valuations have not truly compressed even though yields have risen so sharply.

Similarly, the assumption by analysts that profit growth is set to reaccelerate is questionable. Earnings have essentially been flat for three quarters now. While it is true that the U.S. economy has performed better than expected lately, the global picture is quite bleak with both Europe and China losing steam at an alarming pace.

Companies listed on the S&P 500 derive almost 40% of their revenue from overseas, a number that increases to 60% for the tech sector that has carried the market higher this year. As such, a global slowdown will impact U.S. corporate earnings even if the U.S. economy itself remains resilient. And the strength in the dollar could exacerbate this effect.

Therefore, the question is whether corporate earnings growth can truly fire up by 12% heading into a global economic slowdown. It's crucial to note that this reacceleration is already baked into earnings forecasts, so the risk is that reality does not live up to these rosy projections.

Will something break?

Now to be clear, all this doesn't mean some catastrophic market crash is imminent. What it means is that equity risks seem tilted to the downside, as valuation multiples still don't properly reflect the spike in yields and earnings forecasts appear overly optimistic.

A simple valuation exercise will make this view clearer. If S&P 500 earnings growth next year is only 5%, then earnings would reach 232. Assuming also that the market reverts back to a more ‘normal' valuation multiple of around 16x, multiplying the two together would result in an S&P 500 price of 3,712, which is almost 13% below current levels. Of course, this is only a mental exercise, but it helps illustrate the point.

What could prove this view wrong? The two main upside risks for stocks would be if yields cool down again or if earnings growth exceeds analyst expectations. With the global economic outlook turning darker and U.S. student debt repayments restarting this month, a tremendous surge in earnings appears unlikely.

That leaves a pullback in yields as the most likely saving grace for stocks. For that to happen though, some unforeseen shock might be required that fuels speculation of imminent Fed rate cuts or liquidity injections. In other words, equity markets probably need an ‘accident' to breathe a sigh of relief, similar to the U.S. regional banking crisis earlier this year.

The question is whether any such relief will last or whether it will be overshadowed by the accident itself this time.

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