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Monthly Equity Monitor

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Could multiples expand even more?

Tue, Oct 27 2009, 09:59 GMT
by Economic and Strategy Team

National Bank of Canada

Highlights

• From a low of less than 10 times earnings back in March, the stock market rally has now taken the U.S. and Canadian benchmark indexes to more than 14.5 times 2010 earnings. This puts North American markets among the priciest. At this point we consider 16 times earnings to be a fair upper bound for today’s market. This leaves upside for equities, but less than a few weeks ago.
• Could multiples expand even more? A higher ratio would require higher earnings growth as justification. The consensus of analysts already expects EPS growth of more than 25% in 2010, which is no small order. But rebounds of that magnitude are not unheard of after a recession.
• Another potential justification of further expansion of multiples would be the persistence of low interest rates. Lower interest rates give investors a reason to pay higher multiples for equities. In our expectation, North American central banks will raise rates in the first quarter of the new year. But the futures market still does not expect hikes until further down the road. If the market is right and the Fed stays on the sidelines longer than we expect, P/Es could expand to more than 16.
• We are still keeping an eye on revenues. We have previously said it was a good thing that U.S. companies were busy cutting costs. This helped make them more productive. But cost-cutting alone will not produce a sustainable recovery. Top-line growth is needed if employment is to grow down the road. Companies are now lean. Profit margins of nonfinancial companies are now at 10%, which is high for the end of a recession. Any uptick in sales will give bottom lines a big boost. The consensus now expects this to happen in Q4.
• For the U.S. benchmark, we reaffirm our June 2010 target of 1120 based on earnings of 70. For the S&P/TSX, we reiterate our June 2010 target of 11600 based on our earnings forecast of 725. We realize that these targets are very close to current levels. The next few months will be key for subsequent developments. In the short term, we expect the return of U.S. job creation to be a major market event. Since financial markets are not factoring in a Fed rate hike before well into 2010, a sooner-then-expected return to job creation could shake them temporarily. But in the longer term, employment growth would be the first step toward self-sustaining economic expansion.
• At this point we remain comfortable with our sector rotation strategy. We are still of the opinion that the rally of Canadian Financials from March to August leaves them less room to outperform. We see resource stocks attracting investor attention. The global economy is set to accelerate markedly in the coming months, a development that will support commodity prices.

Could multiples expand even more?

North American equity markets continue to charge ahead. The S&P 500 has advanced 62.3% from the March 9 trough, the S&P/TSX 52.5%. That kind of run-up has some investors thinking the market may not be cheap anymore. Valuations have increased steadily with equity prices. From a low of less than 10 times earnings back in March, the run-up has now taken the U.S. and Canadian benchmark indexes to more than 14.5 times 2010 earnings.

This puts North American markets among the priciest. China’s and Japan’s are more expensive, but not as expensive as a few months ago – they have now slipped below 18 times 2010 earnings. The Canadian benchmark, by way of comparison, is trading at 14.7 times 2010 earnings, the U.S. at 14.6 times and the MSCI World index at 14.3 times.

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Published on  Tue, Oct 27 2009, 10:11 GMT