This Market Makes Sense… If Earnings Grow 19% in Perpetuity
The comments below are an edited and abridged synopsis of an article by Tyler Durden
One of Durden’s favourite fundamental valuation benchmarks (once upon a time, fundamentals mattered) is the Bank of America matrix, which looks at 20 distinct valuation metrics. Recently, the bank’s Savita Subramanian released the latest edition of this table and—to no one’s surprise—it found that stocks are massively overvalued on all 20 counts with two exceptions: forward and trailing price to earnings growth, where the market is roughly 20% undervalued.
But the ‘attractive’ P/E to LTG ratio, or PEG ratio, of the S&P 500 is due to impossible growth expectations, not low valuations. The reason is that consensus expects S&P 500 long-term growth of a stunning 19%, well above tech bubble expectations (chart included). Unless US corporations have entered a golden age for profits, this will not be the case.
Furthermore, as Bank of America admits, long-term growth rates are better contrary than positive indicators,like most sentiment measures. In fact, only 15 out of 87 companies with 20%+ LTG expectations as of 2000 generated 20% EPS CAGR over the next five years.
The sad truth is that, far from indicating the market is undervalued, LTG has a -40% correlation with 12-month forward S&P 500 returns as the chart (included) shows.
As Subramanian ominously summarizes, “today’s level would suggest losses of -20% over the next 12 months based on the historical relationship.”
So if, instead of using this outlier indicator, BofA runs its long-term valuation model based on price to normalized earnings, it forecasts a -0.5%/year return over the next 10 years, putting the S&P 500 at 4,420 by 2031!
There is hope: Dividends are currently close to record lows, and payout ratios are depressed. But if companies increase payout ratios to average levels and grow dividends at trend growth, reinvesting dividends will yield a decade’s total return equivalent to the S&P 500 above 6,000. The question of whether they will do that in a climate where excess shareholder returns are frowned upon by the political establishment is unknown.