Despite the recent selloff, stocks are now in their sixth straight year of gains and are trading at valuations not seen in years. Yet one Fidelity strategist says prices may be justified.
The S&P 500 (^GSPC) is trading at a multiple of around 18 times its trailing earnings. The last time stocks were so richly valued was during the financial crisis when earnings plummeted, according to data compiled by FactSet. Even during the previous bull market’s run-up, the S&P 500 generally stayed below a multiple of 17 times its previous 12 months’ earnings.
But according to Jurrien Timmer, global macro director at Fidelity Investments, this time is different because of low interest rates.
“When you look at history, the average is about 15, the low is around 10, and the high is around 20,” said Timmer about the S&P 500’s multiple to trailing earnings. “People are justifiably saying valuations are around the high side. But that doesn’t account for earnings growth or interest rates.”
Rather than valuing the market as a multiple of earnings, Timmer is instead using a earnings discount model. As the name implies, that method sums future expected earnings discounted by prevailing U.S. Treasury rates plus an equity risk premium.
“It paints a different story,” he said. “With rates relatively low and earnings growth OK, my models show that really valuations are justified at these levels. From my perspective, the market is not expensive here.”
All things being equal, rising rates should lower valuations because future earnings receive a bigger discount. However, Timmer sees the possibility of higher rates as the result of higher growth that, in turn, could lead to higher earnings.
“It depends on the numerator and the denominator of the formula,” he said. “If earnings growth accelerates even if interest rates were to rise, it would still be justified to have P/Es at these levels or even a little bit higher – at 20 or 21. If earnings fall and interest rates rise, that of course would justify much lower P/Es – maybe in the mid-teens. It really depends on both the earnings growth track that we’re on as well as what happens to the discount rate or interest rates in general. Those are really the two main variables here.”
“As long as rates don’t rise in the absence of an acceleration of earnings growth, then a P/E of around 19 or even 20 or 21 is fully justified,” he added.
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