June 8, 2020
What’s behind May’s high S&P 500 valuation? With grim future earnings estimates yet a sharp increase in stock prices, the S&P 500 may be reflecting an overvalued market, according to Paul Markham, global equity portfolio manager at Newton.
In May, the S&P 500 reached its highest forward 12 month price-to-earnings ratio in nearly 20 years.1 Because of this, some experts believe the market may be overvalued at a time when US unemployment is the highest since the Great Depression2 and many companies are suffering revenue loss.
“With interest rates back at all-time lows, due to very aggressive central bank action, bond yields really give investors very little. As a result, equity markets tend to be a default asset class for a few reasons. Despite the fact dividends are being cut in quite a widespread way—there are still higher yields available in equities,” Markham says.
“Also, the fact that you have such a high degree of fiscal and monetary stimulus at the same time, means investors could be looking towards stocks as a hedge against future inflation.”
While near-term inflation seems unlikely, it’s not entirely off the table for the future, according to Markham. Loose monetary policy ultimately places more capital in the hands of the consumer to drive demand. However, if global supply chains remain disrupted, supply may not be able to keep up with the government-induced demand; therefore opening the door for future inflation. 3
However, rising stock prices aren’t just down to investors bracing for future inflation. That would be too simple. Instead, Markham says it’s partially attributable to sentiment surrounding potential Covid-19 vaccinations as well as advancements in containment. But if investors pile into stocks on the basis of sentiment rather than fundamentals, what does that mean for current valuations?
Analysts are expecting a year-over-year earnings decline of 42.9% in Q2 2020, followed by a decline of 24.8% in Q3 2020 and a decline of 12.4% in Q4, before a return to earnings growth in Q1 2021 of 12.4%.4
These forecasts, in combination with a relatively-high S&P 500 forward 12-month P/E ratio may signal the market is somewhat overvalued. Historically speaking, it could be time for investors to be more thoughtful on what exactly they own, according to Markham. In late May, the S&P 500’s forward 12-month P/E ratio of 21.0 was higher than a five-year average of 16.8 and a 10- year average of 15.1. 5
Broadly speaking, Markham says companies related to food delivery, video conferencing and home entertainment have held up well because of their position to benefit from behaviors which have become more prominent throughout lockdown. If economic uncertainty persist, and interest rates as well as bond yields stay low, he expects the environment to favor secular growth stocks.
“There’s a good chance the combination of low interest rates, muted earnings growth and the need for money to find a home, could push equity valuations higher. So you might find that markets can go up without underlying earnings growth and that could lead to sector bifurcation,” Markham says.
“I think you’re going to see some bifurcation between some of the less-impacted sectors— mainly things like healthcare and technology – with the more cyclical parts of the market over the medium term.”
It’s not all black and white
Analyzing the ability for companies to adapt and survive will be key and it’s not as simple as solely avoiding businesses where it’s difficult to social distance, according to Markham. “It’s really difficult for us to know which businesses to avoid and secondly, by going into businesses which don’t rely on workers and customers being in close proximity of one another (i.e. tech space), could we be led down a blind alley when in fact, to change economic and social norms so profoundly is just not feasible,” Markham says. "We would find ourselves in a place where the activities, which the human race undertakes to interact, such as theatre, cinema and visiting restaurants, are no longer viable; not to mention located in buildings not designed for a socially distanced world and no longer fit for purpose. This is an immense social and economic conundrum."
Despite the uncertainty, he has a plan. In an effort to avoid securities that may be overvalued due to the unique nature of Covid-19’s exogenous shock to markets, Markham stresses the importance of selectivity and sticking to long-term growth trends in an environment where valuations may be too high for some companies.
“We’re looking at favorable and attractive businesses, which we think could be winners in the long-term but have been quite expensive in the past, to buy at lower levels,” Markham says. “Where we’ve bought cyclicals, we’ve bought market leading cyclicals—so we’ve tried to keep the quality threshold high.
“We’ve also maintained our weighting to certain areas that are being favored by the market because of their lack of exposure to some of those negative trends such as healthcare.”
1 Business Insider: The stock market is trading at its highest valuation in 18 years, shrugging off skyrocketing unemployment claims and economic ruin (SPY). May 13, 2020.
2 As of May 28, according to Labor Department.
3 The Street: Inflation or deflation, which would be worse right now. May 21, 2020.
4 Factset: Earnings Insight. May 22, 2020.
5 Factset: Earnings Insight. May 22, 2020.
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