S&P 500 record high plus anemic EPS growth equals rich valuation
S&P 500 continues to make new highs ever since surpassing its previous high in late October. At 3093, it is 18.9x our 2019 estimated (E) earnings per share (EPS) of 163.50 dollars (USD), and 18.2x our 2020E EPS of 170 USD. Our 2020 EPS forecast represents only 4% year-over-year (y/y) growth. However, we believe mid-single digit EPS growth can be achieved if trade tension eases and a deal to lower tariffs is signed. If inflation is 2%, which is the U.S. Federal Reserve's (Fed's) symmetric target, then 5% EPS growth is 3% real, which is slightly below but near long-term historical values. To sustain a steady-state price-to-earnings ratio (P/E) (1 / real cost of equity), real EPS growth plus dividend yield must equal the real cost of equity. Given real bond yield (10-year Treasury-Inflation-Protected-Securities (TIPS) yield) slightly over 0%, we estimate the S&P's real cost of equity at about 5.25%. Real EPS growth of 3% with a 2% dividend yield will cover a 5.0-5.5% real cost of equity, which justifies a trailing P/E of 18x-20x on non-GAAP S&P 500 EPS. Based on our intrinsic valuation, S&P 500 at ~3000 or 18.5x 2019 S&P 500 EPS is fair value. So we see current valuation a little rich, but such overshoot is understandable on the optimistic sentiment from developments to reduce trade tariffs and other geopolitical risks including Brexit.
Fair P/E is driven by real EPS growth plus dividend yield vs. real cost of equity
Shareholders are compensated by capital gains and dividend yield. EPS growth drives capital gains over the long-term and EPS retention and reinvestment drive EPS growth (inflation aside). The opportunity cost of retained EPS is a forgone dividend. Thus, anytime a dividend yield is less than the real cost of equity, a company should generate long-term EPS growth that provides offsetting compensation. EPS growth is merely a dividend substitute and is value neutral unless real EPS growth plus dividend yield exceeds or falls short of the real cost of equity. EPS growth above this threshold can be considered value-added EPS growth or rising economic profit. EPS growth below this threshold should receive compressed or punitive valuations. Clearly S&P 500 EPS growth has been sub-par in 2019 and likely runs slightly short of the threshold in 2020 too, but the very low real interest rates compensate partly for such anemic EPS growth. We try to stay disciplined in our S&P 500 valuation, thus not ready yet to apply a P/E above 18.5x at the moment. But if some substantive version of a trade deal is reached and S&P 500 EPS growth prospects brighten, and real long-term yields stay low, then S&P 500 P/E has more upside, and vice versa.
Median S&P 500 ex-Financials trailing P/E is 21x, median forward P/E 19.5x
Financials especially big banks trade at a large discount to the S&P 500. Valuations of S&P 500 ex Financials are richer. The median trailing P/E of S&P 500 non-financial stocks is 21x and median forward P/E is 19.5x, highest since 1985 except for during the Tech bubble. Our P/E/Vix measure shows some complacency in the U.S. equity market and it is not far from the threshold for over-exuberance. All these valuations are at or above the levels that contributed to multiple market corrections in recent years.
Healthy S&P 500 EPS growth needs recovery in manufacturing, GDP less so
U.S. manufacturing is concentrated on heavy industries, producing sophisticated industrial, tech, and health-care equipment. And much of the growth in U.S. manufacturing has been linked to emerging-market (EM) growth and especially EM Asia. China as the largest EM economy has exemplified the stages of EM economic development: export-led, then industrialization and less-sophisticated manufacturing, infrastructure construction, urbanization, to consumption drive, and high technologies. And the demand for U.S. manufacturing has shifted from industrial equipment for producing capital intensive commodities and for construction, to technology hardware, software, robotics, next-gen network etc. In the last two decades, the leading component that has driven the growth in U.S. industrial production is tech related. More than half of S&P 500 revenue is from manufacturing industries, but manufacturing is only 11% of U.S. gross domestic product (GDP). We need to see some trade tension relief and manufacturing recovery for the S&P 500 to return to mid-to-high single digit EPS growth.
Holiday cheer or holiday gloom?: What are the next catalysts for equities
We expect the S&P 500 to be range bound as the overhang uncertainties unfold, with probably slightly more downside risk. How will the trade talks go, if or not a trade deal will be reached, the details of the deal if reached; How the Fed characterizes the health of the economy, what are the next steps of Fed policy; What is the permanent impact of the trade war, how will it affect multinational companies' growth plans and capital allocation. We keep our next 5% price move of S&P 500 as "Down."
Appendix: Performance over the past 5 years (12-month periods)
|10/14 - 10/15||10/15 - 10/16||10/16 - 10/17||10/17 - 10/18||10/18 - 10/19|
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 11/12/19
All opinions and claims are based upon data on 11/4/19 and may not come to pass. This information is subject to change at any time, based upon economic, market and other considerations and should not be construed as a recommendation. Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect. Source: DWS Investment Management Americas Inc.
CRC 071904 (11/2019)