Of course, there are still investors who believe that higher valuation multiples are justified by historically low interest rates. However, I’m not in that camp. Multiples should be driven by expectations for earnings growth. Currently, historically low interest rates reflect subpar economic growth with rising risks of deflation.
That’s not a wonderful scenario for revenue growth or earnings growth, given that profit margins are at record highs. Yet S&P 500 industry analysts are expecting earnings growth over the short term (STEG over the next 12 months) and long term (LTEG over the next five years) of around 10%. That seems a bit high to us, especially for LTEG.
The ratio of the forward P/E of the S&P 500 to LTEG (aka the PEG ratio) was at 1.4 during the week of April 3. That’s not far below previous cyclical peaks, which have all been around 1.5 since 1995. Those peaks haven’t always been associated with the start of bear markets. However, the PEG ratio confirms that stocks aren’t cheap. They are pricing in relatively optimistic earnings growth.
Meanwhile, the bond market seems to be discounting much slower nominal economic growth than the earnings growth rate in the stock market. I view the 10-year Treasury bond yield as the fixed-income market’s assessment of current nominal GDP growth on a year-over-year basis. The latter rose 4.1% during Q4 2013, yet the yield is currently around 2.65%. Again, it seems as though historically low yields should justify higher P/E’s, but the message from the bond market isn’t upbeat about the prospects for higher nominal growth.
Source: Ed Yardeni — Ed Yardeni is the president and chief investment strategist of Yardeni Research Inc., a provider of independent investment strategy and economics research for institutional investors.