September 17, 2018 / 4:15 AM / in a month

High U.S. stock valuations hinge on inflation, interest rates

NEW YORK (Reuters) - Investors are banking on tame inflation and interest rates to support U.S. stock prices and help counter any concerns over an anticipated slowdown in corporate earnings growth next year.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S., September 12, 2018. REUTERS/Brendan McDermid

As they have recently, stocks in general are poised to trade at valuations, based on price-to-earnings ratios, higher than they have traded on average since the mid-1980s, investors said.

Yields on U.S. government securities and consumer prices overall have been moving higher, although they remain relatively moderate. Investors said low bond yields mean reduced investment competition for stocks, and relatively subdued inflation supports low interest rates.

“There’s an argument historically with that type of inflation backdrop and rates where they are, that you can justify a higher valuation,” said Walter Todd, chief investment officer at Greenwood Capital in Greenwood, South Carolina.

The ability of stocks to hold relatively high valuations is important because an expected slowdown in corporate profit growth in 2019 could otherwise temper stock returns. Analysts will increasingly focus on next year’s outlook as third-quarter reports arrive next month.

Spurred by corporate tax cuts that took effect this year, earnings of companies on the benchmark S&P 500 index .SPX are expected to climb 23 percent in 2018, and then 10 percent in 2019, according to Thomson Reuters I/B/E/S.

Stocks are commonly valued by their forward P/E ratios, meaning their prices divided by earnings estimates for the next 12 months.

The S&P 500’s average forward P/E over the past 33 years has been 15 times earnings estimates, but the index has traded above that level for more than two years, according to Thomson Reuters Datastream.

This year, the index peaked at about 18.5 times in late January before the market’s 10 percent correction, and now trades at about 16.8 times.

Interactive graphic: Low inflation, high stock valuations (tmsnrt.rs/2CTrTq7)

Graphic: US stock market valuation over time (tmsnrt.rs/2p5ZRyc)

More than 60 years of data show that the S&P 500 trades on average at higher valuations when the consumer price index (CPI), a common measure of inflation, is rising annually between 0 to 4 percent, compared to when it is higher or when there is deflation, according to Keith Lerner, chief market strategist with SunTrust Advisory Services in Atlanta.

Annual CPI last topped 4 percent about 10 years ago.

When the CPI increases 0-2 percent, the index trades at 16.6 times forward P/E. At 2-4 percent CPI growth, the average is 16.4 times. In the 12 months through August, the CPI increased 2.7 percent, according to data on Thursday.

Lerner calls a P/E of 16 to 17 times a fair current valuation, with global trade tensions and other issues causing fluctuations within that range.

“The way the market is looking at this is a 16 level on a forward P/E basis is pretty good support,” Lerner said.

Equity strategists at Credit Suisse project the forward P/E will drift higher and end 2019 at 18 times. They project the S&P 500 will finish next year at 3,350, a roughly 15 percent rise from current levels.

Credit Suisse equity strategist Patrick Palfrey said tax cuts and other factors are propping up results in 2018, so next year’s decline in earnings growth is less severe that it seems.

This year’s underlying earnings growth is closer to 9-10 percent, Palfrey said, which would be only slightly ahead of the nearly 8 percent expected by Credit Suisse next year.

Credit Suisse also sees limited risk of a recession on the horizon, Palfrey said.

“The economy actually is still moving at a very healthy clip,” Palfrey said.

While current P/Es are higher than average historically, strategists point to a change in the composition over time of the S&P 500, including a greater weight for higher-valued tech companies, as a reason why those historical comparisons may not be as appropriate.

Another factor is the relative attractiveness of equities to bonds and other assets. For example, the earnings yield, which is earnings divided by a stock’s price, for the S&P 500 is currently 6 percent, against a roughly 3 percent yield for U.S. 10-year Treasuries US10YT=RR.

A spike in bond yields would change the valuation equation, could be put to the test as the Federal Reserve is expected to continue its tightening cycle.

Mark Hackett, chief of investment research at Nationwide, said a 4 percent yield on the 10-year U.S. Treasury note would pressure equities, although he doesn’t see that level in the near term.

“Every investment is competition for that next dollar,” Hackett said.

Reporting by Lewis Krauskopf; Editing by Alden Bentley and Bernadette Baum

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