The S&P 500 has surged 14 per cent this year and is at its highest level in more than four years. Not counting 2009 when equities rebounded from their crisis lows, this could be the best year for stocks since 2003 – nearly a decade.
A report showing hiring in the US in August was again much slower than expected and recent warnings of a slowdown at Intel and FedEx, which will likely foreshadow a very weak earnings season, have not been enough to deter investors buoyed by aggressive central bank action.
After the European Central Bank’s pledge to buy the debt of troubled Eurozone countries this week the Fed is widely expected to introduce new stimulus measure in the form of more bond buying when it closes its two-day meeting on Thursday.
“Good news is good news and bad news is good news, largely because of the Bernanke put,” said Eric Kuby, chief investment officer at North Star Investment Management in Chicago.
The S&P 500 is now trading at 13.3 times its forward earnings estimates, meaning investors are willing to pay just over $13 for a dollar of expected earnings from S&P 500 companies.
Although that is below a median forward price-to-earnings ratio of 13.7 since 1976 – according to Morgan Stanley – it is close to the upper end of the range in the low-growth post crisis era of the last five years. During that time there has been a median price-to-earnings ratio of 12.9, according to Thomson Reuters data.
In fact, the recent price-to-earnings high was 13.5 in February 2011, just above current levels. If you are of the view that little has changed since then, there is no reason for the ratio to go much higher. That combined with a slowing earnings picture inevitably means lower prices.
“Our view is that the next double-digit move in the market is down not up,” said Morgan Stanley in a research note.
The analysts believe the S&P 500 will finish the year at 1,214, 15 per cent below where it is now.
At current levels the risk-reward skew is starting to look less attractive then it did. That is especially true given the uncertainty the November presidential elections are likely to generate, as well as the potential for more slip-ups in Europe.
“We put a 1,450 target on the S&P for year and so I’m encouraged,” said Jack Ablin, chief investment officer at Harris Private Bank in Chicago.“But I will say, if this trend continues, I’m inclined to declare victory and move to the sidelines [and] start taking profits.”
The average analyst estimate for the S&P 500 this year is 1,383 according to a Reuters poll from the middle of the year. That shows Ablin is not alone. The S&P’s performance has already outstripped most expectations.
Another negative factor is the rapidly declining earnings outlook for the remainder of the year, as well as for 2013. Analysts are now expecting a 2.1 per cent drop in third quarter earnings year-on-year. About a year ago they were looking for growth of nearly 15 per cent.
This week Jonathan Golub, UBS’s chief US equity strategist, cut his S&P 500 earnings outlook due to a weaker US economic outlook, conversion distortions from a stronger dollar, as well as weaker oil prices.
For 2012 Golub cut his S&P earnings forecast to $102.50 from $103.50 and to $107.00 from $110 for next year.
Golub believes third quarter earnings will be just $25.10, two per cent below the same period last year. On an annualised basis that would translate into an S&P 500 level of just over 1,300 given a price-to-earnings ratio of 13. Signs are that those forecasts are already starting to come true.
Meanwhile, the chances of the Federal Reserve embarking on another round of bond purchases this week have jumped after the disappointing August US employment numbers on Friday, according to a Reuters poll of economists.
The median of forecasts from 59 economists gave a 60 per cent chance the Fed will announce another round of quantitative easing on Thursday.