Stocks’ rally since October has been entirely driven by multiple expansion, especially for large cap growth stocks according to an analysis by StoneX market strategist Vincent Deluard. He argues that while a stock market correction might be required to bring broad indices close to fair value, and that much-hyped tech growth stocks could fall more than the broad averages.
Source: Trading View.
Deluard explains that the stock market is at a crossroads. Stocks have retraced more than two thirds of their losses, the rally of the past nine months meets the technical definition of a bull market for most indices, and bond yields have risen to major resistance levels. For example, the Nasdaq Composite is just 12% off the late 2021 high, and is up 40% the late 2022 low. “Either stocks break out to new all-time highs, or the bear market should resume soon,” he writes.
The Bullish Case
To understand how equity markets got here, Deluard first reviews the bullish case for profitability, growth an multiple expansion:
- A return to the peak corporate profit margins observed in 2021 would justify close to a 30% increase in stocks’ multiples. Whether this happens or not will depend a lot on big tech firms’ ability to cut costs and recover from their current growth slump.
- An increase of about one percentage point in trend growth could justify the expansion in stocks’ multiple. One extra percentage point in trend growth is a lot at a time of ageing demographics, de-globalization, and falling productivity, but the economy has consistently surprised to the upside: (with no recession in 2023, nor in 2024 either.)
- Reducing debt levels will be necessary to contain debt servicing costs. P/Es soared during periods of financial controls in the 1950s, as debt was reduced, boosting stocks’ ability to grow earnings with inflation and making them more attractive than bonds.
Deluard’s base case is for stock multiples to be around 15-16 x, to compete with long-term bond yields of 5-6% Bond yields are under 4% today and that makes stocks still look ‘cheap’. Allowing for the bullish case, he argues that stocks may need to only drop by 10% to restore fair value, under optimistic assumptions. “This optimism does not extend to the most hyped growth stocks, which are in clear bubble territory,” he concludes.
A Multiple-Driven Rally …
The S&P 500 and index returned an impressive 30% in the past nine months as the result of corporate revenue growth, higher profit margins, and multiple expansion. In the past nine months, S&P 500 revenues increased 8%, and profit margins dropped 7% -- so it follows that all the market’s return came from a 28% multiple expansion, with a small contribution from dividends adding 1.3%.
… especially for the Magnificent Seven
This multiple expansion is even more striking at the stock level. The S&P 500 index added $7.6 trillion in market cap since October but, remarkably, $5 trillion came from the expansion of the multiples of the “magnificent seven” tech stocks: Alphabet, Amazon.com, Apple, Meta, Microsoft, Nvidia and Tesla. Nvidia is the most extraordinary example, as its P/E increased six-fold to 205x today from 34x last October. Conversely, the biggest reduction in market caps came from de-rating of value stocks, primarily in the healthcare sector: Pfizer’s P/E dropped from 6.5x to 7.9x, while CVS’ dropped to 9x from 12.1x.
What justifies current valuations?
For the bull to keep running, either profit margins or top-line growth need to keep increasing (or both). Does this make sense? Vincent’s more detailed argument is worth tracking.
- S&P 500 index companies earned $179 per share this past year on sales of $1,780 for a multiple of 20x.
- The current margin rate of 10.1% is about three percentage points below record margins posted in 2021.
- If margins were to revert back to a peak of 13%, S&P 500 companies would earn $231 per share.
- The S&P 500 index could rise by 29% (or 231 divided by179) to maintain its trailing P/E of 20 under this higher margin scenario.
- In other words, the past nine months’ expansion in multiple could be justified if analysts increased their long-term margin forecast to the 2021 peak.
- This is exactly what EPS forecasts point to in the next two years, as shown in the chart below.
Higher profit margins?
The path of margins greatly depends on one’s view of the spike in big tech platforms’ profits during COVID lockdowns, and the extent to which it can be maintained or improved.
- If tech companies’ profits rise back to their 2021 levels, the market should view the ongoing decline in margins as temporary and price stocks for a future peak margins plus.
- However, big tech’s most recent earnings suggest that their COVID profits were indeed extraordinary.
- The revenues of the big five platforms have grown less than GDP in the past year, and their profits have plummeted by 20%.
- Margins might remain under pressure.
S&P 500 Profit Margins
A Structural Increase in Growth?
If margins do not increase, the current expansion in multiples could be justified if the market expected revenue growth to accelerate on a structural basis.
- Stocks’ rally since the October low could reflect an increase in structural economic growth of 1.2 percentage points.
- COVID stimulus might have reset growth, inflation, and interest rates to a higher level.
- The recent expansion in multiples could simply reflect the fact the market has abandoned the recessionist and deflationists fears of the 2010s, and embraced the new reality of the 2020s.
This “higher growth” analysis mostly applies to the US, with China and Europe facing slowing growth, exacerbated by unhelpful demographics.
- About 40% of S&P 500 index revenues come from overseas, and the combined growth rate of Europe and China has fallen to 5% in the past five years from a peak of 12% ten years ago.
- In the past five years, the revenues of S&P 500 companies have grown faster than nominal GDP growth in the US, Europe, and China, which implies that US companies have been gaining market share.
No one can gain market share forever, so it’s unrealistic to believe that the trend growth of S&P 500 companies can keep increasing while overseas growth keeps shrinking.
S&P 500 Revenue Growth versus Nominal Global Growth
Financial restraint cutting debt levels
Next Deluard considers whether stocks’ recent rally reflects the market’s realization that the US is about to enter an era of financial restraint, in which debt levels are reduced? If bonds’ yields are kept negative in real time, the value of stocks’ cash flows, which grow with inflation, should increase relative to that of bonds. This seems inevitable given the level and cost of public debt in the US and other developed economies. US stocks’ multiples did soar when financial repression caused real yields to turn deeply negative after WW2 and during the Korean War.
S&P 500 PE versus Real Yields
Conclusion A Partial Bubble?
Deluard’s bearish view on stocks comes from his belief that secular inflation will eventually force long-term rates to rise, compressing equity multiples, regardless of what happens to earnings. “My back of the envelope calculation is that stocks’ multiples should be around 15-16x to compete with long-term yields of 6%. Based on expected earnings of above $220 per share, fair value should be around 3,400 on the S&P 500 index, a little bit below last year’s low (and an index level of 4,522 compared to now.)
Deluard concludes: “Maybe a correction is enough to bring back the overall market to a sustainable valuation for this new environment, but the most hyped growth stock would have to fall a lot more.”
Analysis by: Vincent Deluard, CFA: Vincent.Deluard@StoneX.com
Report edited by Paul Walton, Financial Writer: Paul.Walton@StoneX.com