Over Priced, Over Valued and Over Here
We recently looked at the relative valuations between European equities and their US counterparts, and we found that European stocks were at the cheapest levels relative to their American counterparts for 17 years.
We found several reasons that explain why this might be the case, foremost amongst these was the ongoing uncertainty around gas and energy prices in Europe. And the fear that limited supplies, during the winter months, could mean energy rationing and short working in some of the world’s most developed economies.
What we didn’t try to assess was whether US Equity markets justified their premium rating, and that’s exactly what I would like to look at in this article.
Let’s begin with this slide from JP Morgan Asset Management’s guide to the markets.
The slide looks at the valuation of the S&P 500, as of the end of August and considers several metrics and compares their current value to their 25-year average value.
What JPM AM found is perhaps surprising, because over these time frames the S&P 500 and its constituents, don’t look overvalued, and in some cases, they look cheap relative to the long-term averages.
For example, the price to book value of the S&P 500, at the end of August, was only fractionally higher than the 25-year average.
Price to Book effectively measures the premium or differential between the underlying value of a company and its assets, and, its market capitalisation, that is the number of shares outstanding * the current price.
S&P 500 stocks also have a higher current dividend yield than their 25-year average and currently return just under 2.0% per annum.
They also trade on a lower inflation-adjusted PE ratio (also known as the CAPE ratio) than the average since 1997. And they trade, only marginally above the 25 year unadjusted PE ratio to boot.
In this chart from FactSet Research, we can see that the rate of change in the price of the S&P 500 index, has fallen back into line with the change in forward PE estimates, having been significantly above them for much of the last two years.
As a result, the 12-month forward PE ratio for the S&P 500 is 16.7 times compared to the 5-year average value of 18.6 and the 10-year average of 17.0 times earnings.
So by historical standards, the largest US blue chips do not look dear. Of course, nearly all the information we have looked at so far compares US equities today with what’s gone before rather than what’s to come.
Our next slide, which once again is provided by JPM AM, may shed some light on what happens next. The chart plots the sources of EPS growth among S&P 500 stocks.
As we can see during 2021 margin growth was the principle source of EPS growth among S&P 500 stocks, far exceeding growth attributable to higher revenues.
However that trend hasn’t continued through 2022, in fact, over the year to date margins have actually made a negative contribution to EPS growth. Whilst the impact of higher revenues has more than doubled.
Margins have fallen because input costs have risen sharply, which is what we would expect to find in an inflationary environment.
However, the concern is that rising costs will not only eat away at profitability but that they will also start to erode revenue growth as well. This helps to explain why the Federal Reserve is so keen to get US inflation under control, so as to avoid an economic contraction.
In summary, S&P 500 stocks don’t look dear when compared to many long-term averages. However, earnings growth looks to be under threat from rising prices and falling margins. Which, if left unchecked could start to undermine sales growth and revenue generation as well.
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