With six months still to go, 2020 has already become the most unforgettable year in recent history. From the catastrophic bushfires in Australia, the impeachment and acquittal of U.S. President Trump, the ongoing COVID-19 pandemic, the oil price shock, the delay of the Tokyo Summer Olympics, to the worldwide outcry for social justice.
While I reflect on the past six months, many questions inevitably arise. What do the bushfires mean for global biodiversity? Who will be the President of the United States come November? When will COVID-19-related restrictions end – when will things be back to normal – will things go back to normal? And what is my part in the fight for equality?
Similarly, as I reflect on equity markets, it’s interesting to find that stock valuations are near all-time highs while the global economy is in recession – which begs the question, why are prices so high?
What does it mean when stocks are expensive? Cheap?
When evaluating the attractiveness of an equity investment, one of the traditional metrics analysts review is valuation. Essentially, the analyst is trying to determine if the investment is relatively cheap or expensive. A common valuation metric is the price-to-earnings (P/E) ratio. This ratio is simply the current share price of the investment divided by the 12-month expected earnings per share of the investment.
So, for example if Company A is trading at $100 per share and is expected to deliver $10 in earnings per share over the next 12 months, then Company A has a forward P/E ratio of 10-times (100/10).
The analyst is then able to take this measurement for Company A and compare it to other companies in Company A’s industry, compare it to Company A’s own history, or compare it to the overall benchmark in which Company A resides. So, if the analyst had two companies to compare and the analyst’s outlook for both were very similar, but Company A traded at 10-times forward earnings and Company B traded at 15-times forward earnings, the analyst might conclude that since both companies have similar outlooks, Company A is the more attractive opportunity because it is “cheaper” relative to Company B and potentially has more upside.
When investors become more exuberant and are willing to pay higher prices relative to future earnings, the P/E ratio increases, or as we call it in the industry, multiple expansion.
2018 through 2019: Strong equity returns, flat corporate earnings, rising valuations
After a steep correction in the fourth quarter of 2018, equities markets around the globe experienced a sharp rebound in 2019. The S&P 500 Index rose 31.5% as the U.S. Federal Reserve eased monetary conditions and the U.S. economy continued to post solid growth. While the S&P 500 posted robust price returns in 2019, corporate earnings in the U.S. did not. In fact, earnings per share for the S&P 500 were essentially flat. As a result, the S&P 500 Index was trading at 18.3-times forward earnings at the end of 2019.
When we compare that to the S&P 500’s own history (going back to 2007, the S&P 500’s longer run average P/E ratio is 14.8-times), we could conclude that U.S. equities are expensive relative to its own history and could argue that further upside potential was limited.
This expensive scenario is referred to as fully priced or priced to perfection. It is generally accepted when equities are priced to perfection that there is little room for error in the economic environment and that any shock will lead to a material selloff.
Enter 2020: Pandemic-related disruptions pull down valuations
With the S&P 500 Index priced to perfection at over 18-times forward earnings in February, the spread of the pandemic was the proverbial wrench in the spokes moment that sent the S&P 500 down almost 34% over the next 4 weeks. The rapid price decline during the months of February and March sent the S&P 500’s P/E ratio down to 14-times forward earnings, lower than its long-run average. This result was expected given the high level of uncertainty in future corporate profitability and the high starting point of over 18-times forward earnings.
However, what came next has been a bit of a surprise.
Valuations skyrocket on pandemic-related support measures
With the global economy heading towards one of the worst recessions in history, central banks around the globe stepped in with unprecedented stimulus injections. For example, the U.S. Federal Reserve decreased interest rates to near zero and purchased almost US$3 trillion in government and corporate bonds to provide liquidity to the financial system. The positive impact on equity valuations has been tremendous.
While corporate earnings forecasts have declined for 2020 and 2021 to reflect the impact of the pandemic on economic growth, equity prices have rebounded dramatically. The S&P 500 Index is now only down 10% from its previous highs.
This material rise in prices combined with the decline in corporate earnings forecasts has pushed the S&P 500’s forward P/E ratio to over 21-times!
Now typically, during recessionary periods, P/E ratios are depressed (readings are generally below long-term averages) as uncertainty is high and investors are skeptical of future corporate profitability. For example, during the Global Financial Crisis of 2008, the S&P 500’s P/E ratio declined to about 12-times forward earnings.
But despite over 45 million Americans having filed for employment insurance, materially declining GDP forecasts, the unprecedented disruption of global supply chains, all resulting from COVID-19-related restrictions aimed to slow the spread of the pandemic, P/E ratios have risen to new highs.
So how do valuations rise so strongly in the short term when corporate profitability isn’t growing? Well there are a few factors that explain the unusual move in valuations:
Low interest rates – The U.S. Federal Reserve depressed its target overnight interest rate range to 0.0-to-0.25%. This effectively lowers borrowing costs and encourages investment. When interest rates are low, valuations tend to increase as investors drive up prices. In addition, with interest rates so low, investor appetite for fixed income investments wanes, making equities more attractive, which also leads to higher valuations.
Massive, ongoing support – The U.S. Federal Reserve has provided approximately US$6 trillion in stimulus to support the economy. For investors, this large injection of stimulus is expected to lead to higher earnings growth in the future, giving them confidence and encouraging them to invest. It’s also important to note that policy makers have been resolute when confirming that they will do what is required to support the economy going forward, further providing confidence and driving up valuations.
As I continue to reflect, it becomes obvious that we are living during a unique period. Adjustments have been made to our day-to-day and we at MD have adjusted our investment views as well. While higher valuations during the pandemic may seem perplexing initially, we do find fundamental justification when we peel back the layers. With that being said, it is wisest to proceed with caution as equities are once again priced to perfection.
For more information, please contact your MD Advisor*. She or he would be happy to answer any questions you may have.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.