As stock valuations slumped in the past year, market pundits debated whether we had any more room to beat them down further. Perhaps a better question is whether we have any more excuses.
The S&P/TSX composite index is priced at a little more than 12 times its estimated earnings per share for the next 12 months (its "forward price-to-earnings" ratio) – a valuation that, while low compared with the market's historical average, is not wildly outside the range of normal. P/Es fell below eight in the depths of the 20008 financial crisis. Even in less unusual circumstances, the current P/Es levels aren't unheard of – P/Es were in the 11 to 13 range throughout the mid-1990s.
But rather than look at precedents, maybe we should look at the reasons P/E multiples have been driven so low in the first place. UBS Securities Canada Inc. equity strategist George Vasic says the key reasons have eased – but P/Es haven't yet responded.
The pressures subside
In a research report this week, Mr. Vasic identified two key drivers of the decline in P/Es over the past year: Risk aversion (fuelled by Europe's sovereign debt crisis) and economic disappointment (fuelled by slowing global growth). Risk aversion caused investors to back away from so-called "risk assets" such as equities, and demand higher returns in exchange for volatility; the disappointing economy caused them to question the growth assumptions built into stock prices. The effect was to drive valuations lower.
But now, Mr. Vasic said, both the risk pressures and the economic disappointments have abated. UBS's global equity risk indicator has returned to historically normal levels, while the VIX index – a measure of volatility in U.S. stocks, usually equated with investors' fear levels – has retreated to an 18-month low, and below its long-term average. Meanwhile, UBS's global growth surprise index has turned decidedly upward, indicating that economic data are again exceeding expectations.
Who needs P/Es, anyway?
That suggests that the downward pressure on P/Es has abated, clearing the way for valuations to creep upward. Still, if investors lack confidence that these improved conditions can be sustained – not an unreasonable stance, given what we've seen the past few years – they may keep P/Es depressed anyway.
But even if P/Es don't rebound significantly, that doesn't mean stocks are stuck in the doldrums this year, Mr. Vasic said. "Solid gains can occur without P/Es returning to normal," he argued.
Mr. Vasic's 12-month target for the S&P/TSX of 14,000 is based on relatively modest 10-per-cent earnings growth and a forward P/E of 12.7 – little changed from current levels and well below the long-term average of 14.5. That would amount to a tidy 17 per cent gain over 2011's year-end price.
"It would not take much of a rise in P/Es to generate solid equity market gains in 2012 – and end the year with multiples still below normal," he said.
David Parkinson