Anyone remember the chart in the right pane below?
You’ll note there’s something particularly unnerving (well, if you’re long it’s unnerving, if you’re on the sidelines it’s pretty funny) there. Specifically, note the part of the table that says “current bull market split between two phases.” See where Goldman breaks down the percent of the index return by contributor during the second phase (2011-2017)? Yeah, so that “71%” part means that three quarters of the index’s return since the 2011 debt ceiling lows is attributable to you (or someone) paying more for every dollar of earnings. Here’s what Goldman said last month:
But the current bull market is really a tale of two sub-cycles (Exhibit 1). During the first phase (March 2009 to April 2011), the market rallied on the back of a rebound in earnings from the depths of the Global Financial Crisis. Higher profits accounted for 66% of the index’s 102% gain while P/E multiple expansion explained just 17% of the rally (faster expected EPS growth contributed the remainder; see Exhibit 2).
Since the market low of 1099 in 2011, the S&P 500 has climbed by 115%. This second phase of the bull market has lasted more than five years and has been driven mostly by an increase in valuation rather than the level of profits. The adjusted P/E multiple climbed to 18x from 10x, explaining 71% of the rise in the index. Higher earnings accounted for just 28% of the rise.
Now I don’t want to get too far into the earnings growth outlook here, but suffice to say that between policy implementation delays in Washington and the following chart which shows you how this usually turns out, I’m not entirely sure that betting on an earnings growth renaissance is a particularly safe bet:
So by extension (and yes, this is a gross oversimplification), the fate of the rally is probably going to be left to multiple expansion which again, has been the case for going on six years now.
Well if you’re in the camp that believes MOAR multiple expansion is possible given the current political and economic backdrop, history says you’ll be disappointed.
Consider the following out Wednesday evening from Goldman who effectively predicts a perfect storm for multiple contraction, noting that “rising inflation coupled with stretched starting valuations, rising interest rates, and the delayed impact of potential policy changes suggest that further P/E expansion is unlikely for the remainder of 2017.”
Rising inflation is usually a headwind for S&P 500 valuation. Since 1985, an increase in the rate of inflation has led to contracting P/E multiples (Exhibit 15). S&P 500 forward P/E averages around 17x when core CPI is between the 2%-3% range but averages below 10x when core CPI rises above 5%. In addition, inflation has fallen during 7 of the 9 valuation expansion cycles since 1980 (Exhibit 17) while core CPI has risen during 6 of the 9 P/E contraction cycles within the same timeframe.
Since the start of 2016, valuation has expanded despite rising inflation due to falling interest rates in 1H 2016 and optimism surrounding policy reform since the election. During 1H 2016, core CPI rose to 2.2% from 2.0% and S&P 500 forward P/E also expanded to 18x from 16x because the US 10-year Treasury yield collapsed to 1.4% from 2.2%. The potential for corporate tax reform and reduced regulation under the newly elected Trump Administration, coupled with strong economic data, have led to valuation expansion and record S&P 500 index levels this year.
Rising inflation coupled with stretched starting valuations, rising interest rates, and the delayed impact of potential policy changes suggest that further P/E expansion is unlikely for the remainder of 2017. Our economists expect that the pace of inflation will increase to 1.9% by year-end 2017 from the current level of 1.8%. Current S&P 500 forward P/E of 18x is at the 90th percentile of historical valuation. We expect the US 10-year Treasury yield will continue to march higher towards our 3% year-end target. Although the S&P 500 has rallied by 10% since the election amidst optimism related to tax reform, the potential benefits will likely only be realized after 2017.