Valuation is often not the immediate trigger for a stock market turnaround. But it is a decisive factor in the amount of upward or downward potential for the market.
Re-rating
Since its low point in mid-June, the S&P 500 Index has risen 18 per cent. Over the same period, earnings per share rose by less than 2 per cent. There has thus been a considerable re-rating of equities over the past two months.
Valuation
Based on the latest observation, the realised P/E ratio has risen to a solid 21. The forward P/E has risen to 19.
Moreover, the realised and forward P/E ratio imply an expected earnings growth in the next 12 months of 11 per cent. This does not match the past. During every significant growth slowdown or recession, earnings and revenue per share fell.
Far from cheap
Price/earnings ratios of 21 and 19 are steep. To be considered ‘cheap’ - defined here as the P/E ratio one standard deviation below the 10-year average - the P/E ratio must fall by 20 per cent.
Even in the optimistic scenario that profits remain flat and earnings growth falls to zero, but does not become negative, the downward potential of US equities is considerable. Conversely, based on the current valuation and priced-in earnings growth, there is little upside potential to distil.
The triggers
So what will be the trigger? As far as I am concerned, there are three candidates that can occur simultaneously. First, the upcoming earnings season is disappointing. This is the most immediate trigger. Secondly, investors bring their earnings expectations in line with economic development, for example, when the ISM Manufacturing Index falls below 50. Third, sentiment weakens as investors get too excited about a possible pivot by the Federal Reserve and refocus on the underlying fundamentals of equities.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His “chart of the week” appears in English every Monday on Investment Officer Luxembourg