Is This Exuberance Entirely Rational?

Earnings estimates for the S&P 500 have dropped consistently each month for the past year. Since the high of $176.76 in September, 2018, the consensus estimate for 2019 has now dropped 7% to $164.45. The consensus estimate for 2020 has also dropped about 7% over the past year to $181.80. Yet for all the concerns about the global economy, trade, and falling earnings estimates, stock prices have been incredibly resilient. As of this writing, the S&P 500 currently stands just 1.7% off its all-time closing high of 3,026.
The chart below shows the decline in earnings estimates for 2019 and 2020 (bars) along with the implied price-to-earnings (P/E) ratios based on those estimates (lines). You can see that the P/E ratio on the current 2019 estimate is back to about 18x while the ratio on the 2020 is now solidly over 16x.   While those ratios aren’t wildly out of line with historical averages, the latter is now about one standard deviation above the 10-year average of a little over 14x.
Source: FactSet
The real surprise, in my opinion, is not the absolute level of the current P/E ratio but rather the market’s resilience in the face of decreasing earnings growth. The chart below shows that the estimated compound annual growth rate (CAGR) in S&P 500 earnings from 2018 to 2020, represented by the blue bars, has decreased from about 10% a year ago to a little above 6% today. This is quite a big drop in just one year. The orange line represents a metric called the “PEG Ratio.” The PEG ratio is computed by dividing the P/E ratio by the growth rate in earnings. This ratio allows investors to consider not just earnings but also earnings growth when determining the S&P 500’s valuation level. The orange line below tells us the PEG ratio has increased from about 149% a year ago to about 259% today. Effectively this means that investors are now willing to pay a higher price (ie, higher P/E) for significantly less earnings growth.
Source: FactSet
It is getting pretty clear that investors are incorporating pretty optimistic developments on both the trade negotiations with China and further interest-rate cuts from the Fed. If one or both of these issues does not unfold as hoped, stocks could be in for some trouble over the balance of 2019. Our advice remains unchanged: long term investors should not try to time the markets, but rather stay invested in high-quality companies that can endure a range of possible scenarios. Expensive markets can remain expensive and become more expensive. While it doesn’t make sense, it happens frequently and can last for years. It seems irrational at times, but we remember the wisdom of John Maynard Keynes who said, “Markets can remain irrational longer than you can remain liquid.” Stay the course, but limit risk.