Trading on stocks – are US equity valuations too high?

Forget the summer doldrums - US stocks continue to pump, with all three of the leading indices hitting record peaks in August. The Dow Jones industrial average, S&P 500 and Nasdaq rocked all-time highs twice in less than a week in the middle of the month.

But are US stocks overpriced? As we head into September and volumes start to pick up again, that’s the big question facing investors.

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Earnings

 

For the first time since the financial crisis, US earnings have fallen for more than a year, according to data compiled by FactSet.  It reports earnings were down 3.2%, meaning company revenues have declined for five consecutive quarters. The last time this happened was the third quarter of 2009.

This beat estimates for a larger fall in earnings, as tech and consumer discretionary recorded upside surprises. But it’s worth noting that the lion’s share of declines was attributable to energy companies, which continue to suffer from weak oil prices. Take out the energy sector and the earnings actually look a lot more positive.

Nevertheless, five straight quarters of falling earnings coinciding with record highs for stock prices ought to raise a few eyebrows. Investors must be optimistic that this is about to change.

Forward multiples

 

The same could be said of the forward 12-month P/E ratio for the S&P 500. At around 18 times next year’s earnings, this ratio now stands at its highest since 2002.

And Energy bags the prize again. According to FactSet, the forward 12-month P/E multiple for the energy sector is sitting at somewhere around 65.

Of course, there is a lot of optimism for earnings in energy over the coming quarters as the fall-out from low oil prices begins to abate. S&P 500 earnings growth for 2017 ranges from 2.5% for Utilities to 15.2% for Materials. Energy, on the other hand, has an estimated earnings growth of nearly 300%.

According to BlackRock, there three reasons to think the US stock market can keep gaining – earnings are likely to recover as year-over-year declines are halted; sales growth is picking up and energy stocks should offer better results going forward.

But while Federal Reserve policymakers argue the US economy is looking increasingly sturdy enough to weather another interest rate hike, companies earnings may not be that resilient. Retail sales data has disappointed and point to the risks about getting overly optimistic around earnings.

Estimates for Q3 earnings still point to a slight fall, which if accurate would mean six straight quarters of declines in company profits.

It is clear investors are bullish about stocks but it’s less clear why, until you consider where else investors can park their cash. Low interest rates around the globe and collapsing bond yields make equities more attractive, particularly those in the US.  Nevertheless, to sustain the momentum and justify the prices, earnings will need to recover.