MILAN – Since the global economic crisis, sharp divergences in economic performance have contributed to considerable stock-market volatility. Now, equity prices are reaching relatively high levels by conventional measures – and investors are starting to get nervous.
The question is whether stock valuations are excessive relative to future earnings potential. The answer depends on two key variables: the discount rate and future earnings growth. A lower discount rate and/or a higher rate of expected earnings growth would justify higher equity valuations.
The S&P’s price-to-earnings (P/E) ratio for the trailing 12 months is close to 20, compared to a long-run mean of 15.53 and a median of 14.57. The Shiller P/E ratio – based on average real (inflation-adjusted) earnings from the last ten years – is at 27.08, with a mean and median of 16.59 and 15.96, respectively. And, in February, the forward 12-month earnings P/E ratio, which uses managers’ future earnings guidance, reached an 11-year high of 17.1, with the five- and ten-year averages standing at about 14 and the 15-year average at 16.
The stock market’s recent performance often is attributed to the unconventional monetary policies that many central banks have been pursuing. These policies, by design, lowered the return on sovereign bonds, forcing investors to seek yield in markets for higher-risk assets like equities, lower-rated bonds, and foreign securities.
According to the standard formulation, stock prices tend to revert toward the present value of estimated future earnings (including growth in those earnings), discounted at the so-called “risk-free rate,” augmented by an equity risk premium. More precisely, the forward earnings yield – that is, the inverse of the P/E ratio – is equal to the risk-free rate plus the equity premium, minus the growth rate of earnings. (Of course, markets take detours along the way, driven by, say, irrational exuberance, temporary declines in the impact of value investors, or mistimed contrarian trades.)
Monetary policy may have bolstered stock prices in two ways, either lowering the discount rate by compressing the equity risk premium, or simply reducing risk-free rates for long enough to raise the present value of stocks. In either case, equity prices should level off at some point, allowing earnings to catch up, or even correct downward.
But the monetary-policy story, while plausible, is not ironclad. Indeed, other factors may explain – or at least contribute to – current stock-market trends.
A key factor is earnings growth. In the long run, it is reasonable to expect that revenue growth would be broadly consistent with economic growth – and, as it stands, there is little acceleration on this front. Earnings can grow faster than revenues for a prolonged (though not indefinite) period, if companies cut costs or reduce investment – a trend that would, over time, lower depreciation charges. In theory, corporate-tax cuts could have the same effect.
Furthermore, the economy’s equilibrium conditions could change, so that aggregate earnings would capture a larger share of national income. There is some evidence that this is now occurring in advanced economies, with the proliferation of labor-saving digital technologies and the globalization of supply chains suppressing income growth.
That said, some trends may be having the opposite effect on expectations for earnings growth. More than two-fifths of the S&P 500’s earnings come from external markets, some of which, like Europe and Japan, are barely growing, while others, like China, are slowing.
The appreciation of the dollar exacerbates the situation for US markets, because it creates headwinds for exporters and causes companies’ foreign earnings, reported in dollars, to decline. And a slowdown in productivity growth, together with excessive leverage and persistent public-sector underinvestment, may be undermining medium-term potential economic growth.
While expectations of faster earnings growth may well be contributing to elevated P/E levels, the current situation is complicated, to say the least. What is certain is that expectations of high earnings growth would have a more durable positive effect on P/E levels than the suppression of the equity risk premium.
The other important factor affecting P/E is the risk-free rate. As monetary policy normalizes – a process that has already begun in the United States – the risk-free rate is expected to rise to a level that is consistent with stable 2% inflation, which, in turn, corresponds with a level of unemployment. What precisely that rate is, however, remains uncertain – and extremely difficult to determine, given that it is affected by virtually every aspect of the unfolding growth patterns.
Nonetheless, several features of current growth patterns stand out: excess productive capacity, persistent high leverage, declining labor content in goods-and-services production, and an increasingly unequal distribution of income both between labor and capital, and across labor-income segments, with their differential savings rates. Together, these patterns could lead to an extended period in which aggregate demand limits growth. With growth not constrained on the supply side, there would be little inflationary pressure, and the neutral interest rate that is consistent with non-inflationary full employment could simply be lower than it used to be for an extended period.
Where does this leave us? In my view, it is difficult to make a strong case for a significant sustained increase in earnings growth in this environment, meaning that growth alone would not justify current equity valuations. But the lower-discount-rate argument is more persuasive, and is consistent with underlying economic conditions and central banks’ mandates.
That said, in such a complex environment, investors can be expected to reach widely disparate conclusions, which will sustain – if not increase – market volatility.
Michael Spence is Professor of Economics at NYU’s Stern School of Business
Copyright: Project Syndicate.