Here at Fort Pitt Capital Group, we often describe the stock market as a “forward looking animal,” and with good reason. It functions as a giant discounting machine, putting a price on unknown future profits and cash flows from thousands of companies. With this in mind, we wanted to examine a few of the economic and market unknowns for the upcoming calendar year 2017, and see if we can create a framework for properly valuing U.S. stocks.
Future stock prices, either singularly or in the aggregate, are a function of two variables: earnings and the multiple (P/E) placed on those earnings. Let’s deal with the outlook for earnings first. The consensus of analyst estimates for aggregate S&P 500 profits for calendar 2016 is $118 per share. This number rises to $134 per share for 2017, a prospective increase of more than 13 percent. A myriad of variables go into creating these estimates, so they are certainly not set in stone. Determining fair value for the index is therefore not simply a matter of slapping a multiple on them and being done with it. First we need to gauge how realistic these estimates are.
We know that analysts tend to be overly optimistic, for example, so profit estimates tend to be biased to the high side. Also, economic growth has been anemic for the entirety of this economic recovery. Odds are it isn’t going to accelerate dramatically over the next year. Given these added variables (and others), we think it prudent to consistently apply a downward “fudge factor” to consensus estimates. Our best guess is that S&P 500 earnings will grow 6 percent to 7 percent in 2017, a rate in line with historical averages. This implies a final result of about $126 per share in earnings for the upcoming year.
Next comes the task of determining the appropriate multiple to place on these profits. Unlike earnings, which are generally a function of corporate performance within a broader economic framework, P/E multiples are largely driven by interest rates. As a rule, if interest rates are low, multiples will be high, and vice versa. Currently interest rates worldwide are near historic lows, with rates in Japan and much of Europe actually negative. This argues in favor of higher P/E multiples, and this is indeed the case in most markets around the world. Currently the P/E in the U.S. stock market is 18.4—twenty five percent above the 14.7 average going back 50 years, according to data from Thomson Reuters.
The key question for our purposes: Can it stay there? What forces might act to either drive it back down toward the long term average, or up above 20? Given that inflation (a key determinant of interest rates) is low and economic growth steady but anemic, fundamentals are unlikely to move it much in either direction. The fly in the ointment is the Federal Reserve. Monetary policymakers have been suppressing both short and long term interest rates for the entirety of this recovery. If they finally decide that the economy is strong enough to absorb a series of interest rate increases, it could cause P/E ratios to begin to trend back down toward the long term average.
To sum up, we think $126 is a reasonable estimate for S&P 500 earnings for 2017. Assuming Federal Reserve policymakers don’t radically change the interest rate regime in place since 2009, our guess is that P/E multiples in the U.S. stock market will remain in the current range of 17 to 19. Multiplying these two gives us a fair value range of 2142 to 2394 for the S&P 500 for year-end 2017, with a midpoint of 2268. This is approximately 5 percent above current levels.