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Bulls frustrated by the stock market’s refusal to rally despite a strong earnings season should remain patient, according to analysts at LPL Financial.
They argue that slightly-above average valuations are justified by still-low interest rates and relatively low inflation and that if earnings growth for the rest of the year remains meets forecasts stocks could be in for a double-digit percentage rise from here.
“When we combine reasonable valuations with solid fundamentals and a positive technical and sentiment backdrop, stocks look like a potential opportunity to us,” wrote LPL Financial strategists John Lynch and Jeffrey Buchbinder, in a note to investors.
Forward price-to-earnings ratios have fallen from about 18.5 to 16.2 over the past three months, according to FactSet. That has been due to a combination of falling prices and rising earnings.
The S&P 500 which hit a record high in late January at 2,872,87 is currently trading at 2,650, about 7% below its peak.
Meanwhile, estimates for 2018 earnings for the index have risen by about 3% since late January, according to FactSet.
“We believe the S&P 500 is fairly valued at a forward PE ratio of slightly over 16, even though that level is a touch above the post-1990 average of 15.4,” the analysts said (see chart below).
The 2019 outlook is also extremely positive. The consensus estimate for earnings-per-share growth is around 10%, while revenues are forecast to grow 5%, according to FactSet.
But not all valuations metrics are created equal.
Trailing PE, which is based on earnings over the past 12 months and tend to be higher than forward PEs, are currently at 21, down from 24 in late January. At 21, the trailing PE is considerably above the 10-year average PE of 17, according to FactSet.
Cyclically adjusted PE, also known as the Shiller CAPE ratio, developed by Nobel laureate economist Robert Shiller of Yale University, stands at 31.5, well above the historical average of 16.9. Shiller and others, however, have emphasized that the CAPE ratio, while a solid indicator of future returns, are of little use in timing market tops and bottoms.
The LPL analysts, meanwhile, argued that historical precedents make a case that shares are fairly priced and could see future gains.
Looking at data going back 50 years, they found that interest rates between 2% and 4% combined with inflation running between 2% and 3% is a sweet spot for stocks in terms of valuations. The average trailing PE for such scenarios, which is where the economy seems to be headed at the moment, is at about 17 to 18.
So, adjusted for inflation and interest rates, stocks are trading only slightly above historical averages, they said.
“This doesn’t mean stocks can’t fall as interest rates rise, especially if rates rise quickly. However, it should provide some assurance to anyone nervous about valuations,” LPL analysts said.
LPL has a year-end price target of 2,950-3,000 for the S&P 500, based on trailing PE of 19.5 and earnings of $152.50 per share. That would be a 13% rise from its current level.
That also suggests earnings will catch up with historical valuations.