Faith, Hope, And P/E Multiple Expansion
Investors have faith that despite the collapse in funding needs the Fed will not Taper anytime soon. Investors have hope that GDP will pick up in the second-half of 2013 (or worst case 2014 or 2015 or 2016) and that's what will drive 'real economy' earnings back from the brink. But most of all, investors today have an un-ending veneration of the P/E multiple-expanding solution to any- and everything in any way negative for stocks. There always seems to be some 'average', some forward-measure, some catalyst for multiples to expand confirming expectations of a round number for a nominal stock index in the future. However, as Morgan Stanley's Adam Parker notes, the humility-arrogance cocktail of forecasting multiples is becoming more troublesome as QE accounts for up to 2 turns for the overall market relative to 'normal' growth and rates.
Via Morgan Stanley,
Will the Price-to-Earnings Multiple Continue to Expand in the 2H of 2013?
The humility / arrogance cocktail: Many investors we talk to think that more multiple expansion in the second half of the year is likely, though many investors use a base case of less multiple expansion from here than we heard in the last 12 months. Most of our frequent readers know we have written extensively about the market multiple over the past two and a half years, and that forecasting the market multiple with data, like growth and rates, is very difficult. The humility one experiences in trying to forecast the market multiple can oddly make one more arrogant than others who think they can forecast the multiple and have no idea what they are actually doing. The humility-arrogance cocktail of forecasting the multiple – you are now served.
Let us stick to some facts, at least for now. Exhibit 2 shows the price-to-forward earnings of the S&P500 over time. These data have existed since 1976, and the median price-to-forward earnings level since then is 13.7x. Admittedly, however, the market has rarely traded at that level for any sustained period. Price-to-earnings ratios are currently slightly above the long-term average.
The P/E frown: Exhibit 3 shows the 80-year relationship between real yields, on the x-axis, and the price-to-earnings ratio, on the y-axis. Multiple expansion has been coincident with higher real rates recently, though the multiple certainly expanded well in advance of higher real rates, beginning in earnest in June of 2012. Ultimately, extreme rates are bad for multiples, so investors must believe that real rates will rise, and that they will be leveling out in a benign 2-4% range. Our colleague Marty Leibowitz calls this the P/E (price-to-earnings) Frown.
QE matters: Our guess is that a number of things have been responsible for the recent market multiple expansion, but perhaps a major contributor was quantitative easing, which encompasses Fed and ECB policy (Exhibit 4). QE mattered historically, which is one reason why forecasting multiple expansion is difficult, as we have written many times. While our recent work has shown a diminishing statistical relationship between week over week changes to the Fed balance sheet and week over week changes to the S&P500, there’s little doubt that the initial phases of the unconventional policy drove higher price-to-earnings ratios. In all, we estimate QE accounts for 1.5 to 2 turns for the overall market relative to what normal” patterns for growth and rates would otherwise imply.
Even with foreknowledge of macro factor directional changes, one is still left with close to a 50/50 bet (i.e., coin flip) on the direction of the multiple.
So it would seem to us that: 1) the Taper knocks up to 28% of S&P 500 value off (2x on a ~14x Fwd P/E); 2) Rate normalization from extremes 'may' help this (though a safety surge will likely bias that to a more negative side as stocks slipped); and 3) forecasting this on any 'factual' piece of data is a coin-flip and therefore worthless when listening to the mainstream media.
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