Mario Tama
How far has the stock market's fall from grace been in this spring's selloff? Far enough that investors are now valuing U.S. stocks like junk bonds.
Pierre Lapointe, global macro strategist at Brockhouse Cooper in Montreal, wrote in a research note Wednesday that based on Wall Street's consensus earnings forecasts for the next 12 months, the S&P 500 is now trading at an annualized earnings yield of 8.4 per cent. (Earnings yield is annual earnings per share as a percentage of the stock price - essentially, the price-to-earnings ratio flipped upside down. When P/E valuation falls, earnings yield rises.)
"In other words, to put money in stocks, investors are requiring a rate of return of 8.4 per cent. This is almost as much as junk bond yields (currently at 9 per cent). The spread between the two measures is now the smallest on record," Mr. Lapointe said.
Mr. Lapointe blamed the junk-bond-like valuations on the surging risk aversion that has built up in the markets as a result of the rising European debt worries. But, he argued, it's gone too far.
"Any way we put it, we do not see how the estimated risk on the 500 largest U.S. stocks could be nearly as high as junk bonds," he wrote. "Heightened risk aversion for equities has created a market dislocation."
Mr. Lapointe acknowledged that there may be another explanation for this anomaly - that the market thinks earnings estimates for the next 12 months are unrealistically high. But if that's the case, he said, Wall Street analysts don't agree. They have raised the S&P 500 consensus forecast by 3.3 per cent in the past three months.
But Gluskin Sheff + Associates chief economist David Rosenberg believes the earnings forecasts for the next 12 months are, indeed, much too high for this stage in the economic recovery - and that has distorted stock valuations.
"If your assumption is that we're going to be back at peak earnings as early as next year, then yes, P/Es are very cheap," he said. "But in times of economic turbulence, you should beware of earnings estimates."
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Mr. Rosenberg believes the still-bullish Wall Street earnings forecasts are failing to account for a slowdown in growth in the second half of this year and into 2011, as spending constraints of many governments put the brakes on the stimulus-stoked growth that the world's economies have enjoyed in recent months. Seen through that lens, the consensus S&P 500 earnings forecast - which projects growth of better than 30 per cent in 2010 - could be difficult to achieve.
"I find that multiple really hard to swallow," he said.
Tobias Levkovich, chief U.S. equity strategist at Citigroup, argued that even if you believe stock valuations have gotten too cheap relative to earnings expectations and junk-bond yields, that's not necessarily proof that stocks are set to rally.
"Stock prices aren't driven by valuation. It is a necessary, but insufficient, condition. It's not a catalyst for change by itself."
Mr. Levkovich noted that even when the gap between earnings yields and junk-bond yields are unusually narrow, as they are now, history shows stocks aren't any more prone to rise over the following three to six months as they would be at any other time. Over the shorter term, he argued, other concerns are often more pressing than valuations.
"There are concerns about sovereign risk and their impact on growth. There are concerns about a double-dip. We do think some of those risks are overstated. But that doesn't mean stocks are going to go up - at least not in a time frame that people feel comfortable with."
David Parkinson