Low PE ratios point to slow global growth

The equity markets are pricing in a significantly slower growth for most of the world than we've experienced in the past decade. In spite of the MSCI World Index (global equity index) being up some 11% year to date, the price to earnings ratios (PE) remain at the low end of the range for all major equity indices except for the UK. Low PE multiples tend to indicate slower growth expectations.

PE ratios relative to the range from the past decade (Source: Barclays Capital)

Emerging markets in particular (driven by China) are priced for much weaker growth rates relative to historical levels. Australia and the US are also trading near the bottom of the PE range.

SoberLook.com

Persistent resilience of the US equity market

The US equity market continues to stay resilient after beating every major equity market globally in 2011. This is upsetting many investors, as numerous fund managers and individuals are underinvested or short. We are still getting angry emails about the October 15th post called "It's green light for the US equity market - for now". In spite of all the dire predictions however, the S&P500 is up nearly 6.5% since that post.

S&P500 performance since Oct 15th

Going forward we may in fact see some pullback given this quick rally.  We may also have some headwinds from the US budget issues and an uncertain employment picture.  Europe will continue to weigh on this market even if the US stages a partial decoupling from the eurozone issues.

Longer term the US equity picture remains benign.  With the S&P500 dividend yield above the 10-year treasury rate and PE ratios of around 12, the market is not overextended.

SoberLook.com

On the way to euphoria

As the US equity market rally continues, many point out that the S&P500 is still 21% below last year's level. We still have ways to go just to get to last year's levels. Stocks are still cheap. Right.

The chart below shows the S&P500 level as well as the PE ratio, both the trailing ratio and the estimated PE (based on Bloomberg survey). Both PE ratios are at multi-year highs. The projected PE number of nearly 17 times earnings is particularly troubling because it's a forward looking measure. These levels indicate that equities are really expensive.



So why are people buying stocks with such enthusiasm? A few possible reasons here:
1. analysts are completely underestimating next year's projected earnings,
2. earnings growth in the next few years will significantly exceed historical growth,
3. stock market euphoria is back.

According to Credit Suisse, number 3 is more likely, or at least on the way there. The following chart shows the levels of risk appetite in the system, and we may be on our way from "panic" to "euphoria" in a matter of a few months.



Euphoria has been known to carry asset levels way beyond fundamental valuation, and that's exactly what may be happening here.

Equities overpriced relative to credit

The historical average for S&P500 PE ratio over the past few years has been around 16. We are currently at the trailing PE of 15 and the estimated PE of 16. US equities are now at their historical average multiples. All the risk premium in equities has been taken out!

S&P500 level and PE ratio


But that's not at all true for credit. In spite of the massive rally we've experienced, investment grade corporate credit spreads are around 390 bp vs. pre-crisis levels of just above 100 bp. Equities are now looking completely overpriced relative to credit.

JPMorgan blended corporate investment grade spread


Update: some are questioning Bloomberg's estimated PE number. Here is an estimate from S&P as a comparison (consistent with Bloomberg's estimate of 16) - see page -2:

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