How compelling are equity valuations?

Relief over the results of the US bank stress tests, better than expected US jobs data, generally less negative economic data in general, as well as better than expected Q1 earnings provided markets with plenty of fuel over recent days and weeks. This has helped to spur an improvement in risk appetite and a resultant strengthening in equity markets. Meanwhile, government bonds have sold off, commodity prices have risen and the USD has weakened.

At the time of writing the S&P 500 has recouped all its losses for the year, having climbed around 34% from its low on 9th March. To many this has sent a bullish signal about the path of the economy ahead given the historical lag of around 5 to 6-months between equity gains and economic recovery but to others include myself this is sending a false signal. Even if the economy stabilizes any recovery is likely to be slow.

As stocks have risen, cautiousness about the current rally has intensified, with many now calling for equities to correct lower. This could partly reflect sour grapes from those investors who have missed the move in equities (I like to think that I am not in this camp even if I did miss the move) but there is also an element of truth in terms of equity market valuations, which have risen sharply over recent weeks. Although arguing whether stocks are cheap or expensive depends on what measures are used there is even some caution coming from equity bulls.

Bloomberg estimates one measure of equity valuation, the Price / Earnings ratio of the S&P 500 at 14.78, which is still below the estimated P/E ratio of 15.96 but much higher than the P/E ratio of around 10 at the beginning of March. Other estimates also suggest that the current P/E ratio on the S&P 500 is approaching a long run average, which suggests that further upside for equities may be more difficult in the weeks ahead.

What now? So far markets have reacted to the fact that economic conditions are the past the worst and the reaction has reflected less negative economic data releases, with many data releases coming in ahead of expectations. Going forward, it will require actual positive news as opposed to less negative news to keep the momentum going. If positive news is lacking the improvement in risk appetite and equity market rally will falter, especially as valuations are arguably far less compelling now.

I would be interested in your view about whether you think the rally will continue. Please tick the the relevant circle in poll on the sidebar to give your view and also view what others are thinking.


5 Responses to “How compelling are equity valuations?”

  1. UP Says:

    I agree that where we go from here will largely depend on the data – ie if the data doesnt support the market vals, then the mkt will drop, and quite possibly very quickly. However, the wider problems still do exist namely unemployment will rise, growth will slow, spending with contract and eventually, they world will have to manage with the large fiscal support that it has had. This surely cant be good news for equities.

  2. US dollar under pressure « ECONOMETER Says:

    […] some positive news as opposed to less negative news to keep the momentum in equity markets going (see previous post) the prospects for a stronger dollar remain limited. […]

  3. Anne Cheung Says:

    Hello Mitul,
    I found your comments interesting & very insightful, and I feel the direction the economy takes will be dictated by sound analysis of the data available.

    • Mitul Kotecha Says:

      Thanks Anne, I think the problem is that the analysis of the data so far has fuelled over optimistic expectations of recovery which will lead to greater risk of disappointment in the event of a slower recovery.

  4. Watch out for the pitfalls in H2 2009 « ECONOMETER Says:

    […] the market rally may have been justified so far but there is little to carry the momentum forward. Equity valuations dropped to low levels in March but can be hardly considered cheap at present. The improvements in […]

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