Thursday, February 6, 2014

Valuation & Earnings Growth (excerpt)

The plunge in valuation multiples since January 15 is reminiscent of similar downdrafts during previous corrections of the current bull market. There are many valuation models, but most strategists agree that P/Es are significantly influenced by the prospects for interest rates and earnings growth.

I focus on the Aaa-rated corporate bond yield (compiled daily by Moody’s) and analysts’ consensus expectations for S&P 500 earnings growth over the next five years (compiled by Thomson Reuters I/B/E/S). I find that the trends in the spread between these two important variables are similar to the trends in the forward P/E of the S&P 500. The bond yield has been edging lower this year, while growth expectations remain relatively high around 11%-12%.

Given recent developments among emerging economies and some weaker-than-expected indicators for the US and Europe, investors seem to be reassessing the prospects for earnings growth and reducing the valuation multiple they are willing to pay for earnings in a slower-growing world.

I think investors may be overreacting to some of the weak indicators, particularly January’s M-PMIs for China and the US. Interestingly, J.P. Morgan’s Global PMIs remained near recent cyclical highs during January for the composite (53.9), manufacturing (53.0), and services (53.8).

Today's Morning Briefing: Something Wicked This Way Comes? (1) Another anxiety attack. (2) Will tapering trigger an EM-led contagion? (3) From East Asia EMs to US subprime mortgages to EZ-PIIGS. (4) Message from a friend in UK. (5) Less irrational exuberance in P/Es. (6) Are investors turning too pessimistic on revenues growth? (7) Is it different this time for profit margins? (8) Risk to margins may be weak pricing rather than rising costs. (9) Focus on overweight-rated S&P 500 Financials. (More for subscribers.)

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