C.J. Lawrence Weekly – The Tug‐of‐War Between Lower Valuations and Faster Earnings Growth Still Skews Towards Growth
There are multiple reasons cited for last week’s equity market blow off. It’s difficult to know which event set the downdraft in motion but the rapid rise in interest rates, after several years of historically low rates, is a good place to start. The U.S. Benchmark 10-Year Treasury Yield finished the week at 2.85%, up 39 basis points in just one month. It’s probably fair to say that the market has been expecting higher interest rates, but has been hoping for a more gradual climb. Recently released economic data, has confirmed that both the U.S., and global, economic recoveries are accelerating and inflation is beginning to push through. The U.S. bond market is recalibrating to higher economic growth expectations.
The classical cycle of an economic recovery leading to higher inflation and interest rates looks intact. But a signal may be developing at the long end of the yield curve questioning the rate of change in inflation, versus the rate of change in growth. Yield curve disciples cite the short end of the curve as being most responsive to Fed policy, the middle-to-long portion of the curve most sensitive to economic activity, and the longest end of the curve most susceptible to changes in inflation expectations. Over the past twenty years the spread between the yields on the U.S 10-Year Treasury Bond and the U.S 30-Year Treasury Bond has averaged 63 basis points. That spread now stands at 24 basis points. The ratio bears watching as the 30-year bond is the maturity least impacted by Fed policy, and may provide the best barometer of inflation expectations. Inflation that stays lower for longer could slow an equity market valuation re-rating, precipitated by higher short rates.
Growth and inflation expectations impact the relative value of stocks versus bonds, as reflected through the market multiple. Our CJL Rule of 20 tells us that an economic environment with 2.0% inflation can accommodate an 18x price-earnings (P/E) multiple on current year earnings. Thus, should inflation climb towards 3.0%, the appropriate multiple would likely trend towards 17x current year earnings. At 17x the consensus 2018 EPS forecast of $155, the fair market value for the index would be around 2,635, or 4.5% below the current level. But that is a static calculation that does not incorporate faster earnings growth, which should be assumed if inflation trends towards 3%. For stocks to offset a potential negative re-rating, earnings will need to grow faster than the rate of decline in the market multiple. This is happening. In just the past two months, bottoms-up earnings forecasts for the S&P 500 have climbed 7% for 2018 and 8% for 2019. Estimates are likely to climb higher as the remaining 50% of S&P 500 constituents report 4Q17 earnings results and issue guidance for 2018. The race between earnings growth rates and the rate of decline in the market’s P/E multiple is on. Along the way, the 10-30 year treasury bond spread may provide insights into the appropriate market multiple to apply. The challenge for equity investors will be to find stocks with earnings growth rates that exceed the rate of decline in P/E multiples. Based on current forecasts, they can be found in the technology and financial sectors. We remain overweight in both.
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