Earnings boost for stocks may lose luster with rising yields

Global Stock markets

There is little doubt on Wall Street that U.S. corporate profits are on track to rise at a healthy rate this year, with an overall estimate for growth of almost 20 percent. 

Less certain, however, is how investors should value those profits with price-to-earnings estimates. The struggle to do so could lead to more stock market volatility. 

The valuations issue has gained fresh prominence for market strategists amid a rise in interest rates and bond yields, along with concerns about inflation increasing. 

Those factors, including a yield on the benchmark 10-year U.S. Treasury note US10YT=RR that is approaching 3 percent, has prompted investors to rethink how to price stocks, which have become more expensive as the nearly nine-year bull market has aged. 

Indeed, some investors are weighing whether equities deserve lower valuations. 

A test for equity valuations could come with next Friday’s U.S. employment report for February. 

Last month’s report revealed surprising wage gains that sparked concerns of inflation, in turn setting off a jump in yields and drop in stocks. 

Stocks are commonly valued by comparing their price to their estimated profits over the next year, known as the price-to-earnings, or P/E, ratio.

VOLATILITY

The P/E ratio on the benchmark S&P 500 index .SPX had climbed to 18.6 times by the end of January, the highest level in about 15 years. 

That was just before the market plunged at the start of February, dropping 10 percent and confirming a correction, and in turn lowering the P/E ratio to 17 times earnings estimates.

The S&P 500 fell 1.3 percent on Thursday after President Donald Trump said the United States would impose tariffs on steel and aluminum, raising concern about higher prices and a trade war, though that made the index’s valuation only modestly cheaper.

Half of the S&P 500’s returns last year stemmed from the P/E going up - investors willing to pay more for future earnings - helped by optimism about the global economy.

The good news for stock investors is that S&P 500 earnings are expected to jump 19.2 percent in 2018, the biggest increase since a 40.3 percent rise in 2010, as the United States emerged from the financial crisis.

An examination of the six other years in which S&P 500 earnings growth topped 15 percent, along with increasing 10-year Treasury yields and the Federal Reserve raising interest rates, found that P/E multiples shrank in all but one year, but the index still managed gains.

Lerner expects the stock market will be able to maintain a forward P/E of around 16 times. 

That is cheaper than current levels, but above the S&P 500’s long-term average of 15 times.