NEW YORK (Reuters) – There is little doubt on Wall Street that U.S. corporate profits are on track to rise at a healthy rate this year, with an overall estimate for growth of almost 20 percent.
Less certain, however, is how investors should value those profits with price-to-earnings estimates. The struggle to do so could lead to more stock market volatility.
The valuations issue has gained fresh prominence for market strategists amid a rise in interest rates and bond yields, along with concerns about inflation increasing.
Those factors, including a yield on the benchmark 10-year U.S. Treasury note US10YT=RR that is approaching 3 percent, has prompted investors to rethink how to price stocks, which have become more expensive as the nearly nine-year bull market has aged.
Indeed, some investors are weighing whether equities deserve lower valuations.
“It’s a topic that’s got to be in the front of a lot of asset managers’ minds right now: What level is this market a really good buy again?,” said Jim Paulsen, chief investment strategist at The Leuthold Group in Minneapolis.
“We are going to get good earnings coming through,” Paulsen said.“The problem is we are going to lose the value on those earnings.”
A test for equity valuations could come with next Friday’s U.S. employment report for February. Last month’s report revealed surprising wage gains that sparked concerns of inflation, in turn setting off a jump in yields and drop in stocks.
The good news for stock investors is that S&P 500 earnings are expected to jump 19.2 percent in 2018, the biggest increase since a 40.3 percent rise in 2010, as the United States emerged from the financial crisis, according to Thomson Reuters I/B/E/S.
An examination of the six other years in which S&P 500 earnings growth topped 15 percent, along with increasing 10-year Treasury yields and the Federal Reserve raising interest rates, found that P/E multiples shrank in all but one year, but the index still managed gains, according to Keith Lerner, chief market strategist with SunTrust Advisory Services in Atlanta.
Lerner expects the stock market will be able to maintain a forward P/E of around 16 times. That is cheaper than current levels, but above the S&P 500’s long-term average of 15 times, according to Datastream.
According to a Reuters poll of market strategists this week, stocks will rack up a gain of more than 8 percent for the year, despite the recent correction.
“We are not relying on multiple expansion. In fact, if rates continue to rise like this, we are looking at probably a little bit more of a contraction scenario,” said Mona Mahajan, U.S. investment strategist at Allianz Global Investors.“But this will be offset by strong (earnings) growth.”
But Paulsen said he believed stocks may be overpriced and that Leuthold recently reduced U.S. equity exposure in its main funds. Among his concerns was whether inflation is about to rise more sharply.
“We have given birth to a whole new generation of investors that have rarely seen inflation at even 3 percent,” Paulsen said.
“If you are going to generate some negative fallout from additional growth, however much longer this recovery lasts, that creates a very different environment.”
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