Is there something particularly notable about a 17x trailing PE multiple on the S&P 500? According to Deustche's David Bianco, there is especially during mid to late cycle expansions, i.e., after three (or much more in this case with the S&P 500 now repoting 5+ years of EPS growth) years of rising earnings. In fact, as DB calculates, the only two periods of a PE over 17 after 3 years from the last EPS decline are 1965-66 and 1996-98 (Figure 2) below. And right now. It should be self-explanatory that both of those historic periods ended with a sharp equity correction.
So how does the German bank explain the current outlier phase? Simple: "long-term interest rates this low are more rare and support a higher PE." In other words, all those who scream bond bubble, are blissfully ignoring the fact that it is these low rates that are permitting the spin that allows already stretched equity valuation to get stretched-er and approach David Tepper's magical 20x as a "fair value" for stocks.
And the culprit at the bottom of it all? Why the Fed, of course, with its disastrous policies, because in a normal world, a 2.4% 10Y would signal an impending economic disaster, only this time it suggests, conventional wisdom "explains", a green light because there no longer is a market that can be taken at face value thanks to the Fed's endless manipulation of every single asset class.
In any event, back to the 17x PE and how one should read it:
Above 17 PEs are rare after many years of EPS growth, but very low interest rates are more rare and support higher PE
For the S&P 500, since 1960, the month end PE on 4qtr trailing EPS exceeded 17 in 42% of all months. However, most PEs at month end above 17 were after recessions when EPS was still cyclically depressed or after 4qtr S&P EPS declined outside of recessions such as in 1967, 1987, and 1998. It’s been 5 years since a US recession and 5 straight years of S&P EPS growth, the record stretch for EPS growth being 6 years from 1992-98. The only two periods of a PE over 17 after 3 years from the last EPS decline are 1965-66 and 1996-98. Thus, the PE is usually under 17 unless investors view EPS as below trend. But the PE was sustained over 17 on normal EPS from 1964-66 and 1996-2000, which represents a large but concentrated portion of mid-cycle years. The PE was a bit over 17 in 2+ years post recession briefly in early 1973 and mid 1987.
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There are seven multi-year periods with PE above 17 (shaded in the table), while most of these periods were early to mid cycle years there were also the extended mid cycle years (5.5 years) of the mid and late 1960s, the 5 years of 1996-2001. These 7 periods with PE above 17 that lasted more than 1 year are relevant for helping determine the likelihood of today’s PE staying above 17 for an extended period. The 7 bolded periods are those with PE above 17 and are periods 2 years or more after recessions. The above 17 PE in these periods are not due to cyclically depressed earnings following recessions, and they are 20% of all periods.
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So how does one justify this relentless multiple expansion? Simple: near record low rates, which in a normal world would presage a deflationary collapse which in turn would be extremely bearish for stocks. Only this time it's different.
Interest rates go in only one direction this year. Despite improved US growth trends, a tighter labor market and arguably lesser geopolitical risk, this week long-term treasury yields set lows for the year. Other than pointing to Europe’s inability to sustain growth and falling European yields, this persistent decline in treasury yields is astonishing. Although the uptick in labor force participation mitigates the risk of overnight rate hikes starting early next year, higher overnight rates are still on the visible horizon. Thus, powerful global structural trends appear at work and we find ourselves more accepting of long-term risk free real interest rates staying well below historical norms through the cycle. The completion of a good earnings season, improved confidence in decent US growth and S&P EPS growth for at least the rest of the year, and these still exceptionally low interest rates is shifting risk firmly to the upside for our longer-term fair value S&P 500 targets. We increasingly see the currently observed PEs as fair with upside at Tech, Healthcare and Financials, partially offset by Energy, with further overall S&P price gains fueled by EPS growth.
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What is left unsaid is that the moments rates go up beyond the max pain point for algos and "risk parity" strategies, equities sell off and the proceeds go where? Right back into Treasuries whose sell off caused the equity sell off in the first place. Rinse. Repeat. Which just happens to be the closed loop that the Fed has created with 6 years of direct intervention, and whose breakage will be far less pleasant than its creation...
