Nomura’s Michael Kurtz has declared that it’s the “
end of the end of the world.”
In forecasting the performance of the S&P 500, Kurtz argues that we could see further expansion in the price-earnings ratio (PER), which means prices will grow faster than earnings. And this PER expansion could come as interest rates begin to rise.
Figure 46 shows a strongly positive correlation between US Treasury yield changes and changes in the S&P 500 forward PER. While we would not presume to venture too scientific an analysis here, in approximate terms the conservative 50 bp increase in Treasury yields that our rates strategists look for by end-2014 appears consistent historically with an S&P 500 forward PER expansion of up to 1.5 multiple points.
This, then, could lift the S&P 500 forward PER from roughly 15.0x currently to between 16.0x and 16.5x — or a plausible 0.5 standard deviation above its long-term mean of 15.2x. But because our end-2013 S&P target of 1,780 assumes an “actual” 12-month forward PER (i.E. adjusted for our more conservative US$112.50/sr 2014 EPS estimate) of 15.8x, that would mean only a small (roughly 2-3%) actual margin expansion in 2014 (i.e. to roughly 16.3 from an ‘adjusted’ 15.8 currently).
Allowing for a modest 2%-3% upside from such an ‘actual’ multiple expansion (i.e. adjusted for our rather than consensus EPS forecasts), and taking into consideration our current S&P 500 EPS growth forecast of roughly 6% — and assuming a similar growth rate in 2015 (as our US nominal GDP growth forecast for that year largely plateaus from 2014 — we arrive at an end-2014 S&P 500 index target of 1,925 (7% above current levels)…
Deutsche Bank’s David Bianco shares this assessment. From Bianco’s Nov. 17 note to clients:
The S&P’s forward PE on mid-cycle EPS (or more than 2 years after recessions) has never significantly exceeded 16 other than the late 1990s, when high PEs were assigned mostly to Tech stocks for their assumed strong economic profit growth. In our view, further S&P PE expansion from 15x 2014E EPS today would be justified if long-term treasury yields slowly rise as the Fed tapers, but plateau below historical norms (~4% 10yr, ~2% 10yr TIPS or less). The less the Fed’s balance sheet expands in 2014 the less the risk that yields rise above historical norms when QE ends or when the Fed’s balance sheet contracts.
Rising rates are generally associated with an improving economy, which may explain why investors would be willing to pay an increasing premium to earnings.
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