Sir John Templeton, Anglo-American mutual fund pioneer and founder of the Templeton Growth Fund, famously said: “The four most dangerous words in investing are: ‘This time it’s different.’”
This time, it is definitely different, argue S&P 500 bulls who are banking on a stronger economy in the coming months to justify the market’s current lofty valuations and puncture the growing rumbles about a brewing stock market bubble.
This week on the back of yet another record close just shy of 1,900, the S&P 500 bull market entered its sixth year.
The upward march of US equities in recent years has propelled the broad US benchmark well beyond its prior peaks seen in 2000 and 2007. Those twin peaks just above 1,500 were subsequently followed by brutal bear markets.
Last week, Richard Fisher, president of the Federal Reserve Bank of Dallas issued a blunt appraisal of US equities and how the rally has been driven by the central bank’s easy money policy.
“Stock market metrics such as price to projected forward earnings, price-to-sales ratios and market capitalisation as a percentage of GDP are at eye-popping levels not seen since the dotcom boom of the late 1990s.”
Including the reinvestment of dividends, the S&P 500 has risen 210 per cent since it bottomed during the financial crisis in early March 2009. It is a rally that has been led by cyclical stocks, those that reflect the fortunes of the economy.
Even the most ardent of bulls concede the market is fully valued when they look at various measures, leaving it ripe for a major pullback at the very least.
Against a backdrop of emerging market worries, inconsistent US data and a Federal Reserve prepared to steadily reduce its monthly bond purchases under quantitative easing, the rationale for buying the S&P at current levels is the expectation of a stronger economy in the coming months.
“We would say equities are no longer cheap and that stronger economic growth will be needed to drive earnings and prices higher,” says Russ Koesterich, global chief investment strategist at BlackRock.
After a harsh winter that has overshadowed recent US economic activity, it is hoped that the arrival of spring will spark a renaissance in growth that vindicates such high valuations.
The S&P trades at a forward 12-month P/E ratio of 15.4 times, based on a 12-month forward earnings per share estimate of $122.01 says John Butters, analyst at FactSet. That figure sits well above the five year average of 13.2 times and the 10-year average of 13.8 times.
“With the forward P/E ratio well above the 5-year and 10-year averages, one could argue that the index may now be overvalued,” says Mr Butters.
Nicolas Colas, chief market strategist at ConvergEx Group says such hefty valuations, “require that expectations for revenue and earnings growth are not just hopes and dreams, but promises fulfilled.”
He adds: “On the flip side, if the global economy, led by the US, can begin to accelerate in the back half of 2014, then we are finally well set up to beat expectations going into 2014.”
For some, such as Jim Paulsen, chief investment strategist at Wells Capital Management, 2014 is the year the economy heats up, with the danger that an inflation scare eventually sparks a major pullback once the S&P has reached 2,000.
The key ingredient for the bullish case is a forecast acceleration in quarterly revenue growth for 2014, seen peaking at 4.5 per cent for the third quarter. Up to now, aggressive cost cutting from companies has boosted earnings when revenue or top line growth has only expanded at around 1 per cent over the past year according to FactSet.
The disconnect between earnings and top line growth has been ignored for some time by bullish investors even as the Fed has started trimming its bond buying under QE.
The suppression of interest rates, thanks to several rounds of QE, has pushed both equity and housing prices sharply higher in recent years. That has resulted in the net worth of US households approaching its 2007 peak. As Barclays notes: “US households have never been wealthier, in US dollar terms or adjusted for inflation.”
One pressing issue for bullish investors and policy makers is whether this rise in household net wealth, up $9,800bn at $80,864bn during 2013, will finally propel the economy into a higher gear this year. Or whether companies sitting on record piles of cash, start pumping it into capital investment projects and hire more people.
Should the current soft patch extend into the Spring, equity bulls face coming to terms with Sir John Templeton’s warning about assuming it’s different this time.
“As we see it, even if S&P 500 activity is not to be considered bubble-like behaviour, a continued divergence between stock prices and economic performance means that arguments to the contrary will surely grow more convincing,” says Neil Mellor, strategist at BNY Mellon.
“Given a shift in the balance of opinion it then becomes simply a question of whether stock prices slide imminently or just put in further gains of 20 per cent before doing so.”