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Another worry we have about stocks in the near term is the fact that almost all of the gains over the past year have been from a higher earnings multiple on stocks as opposed to earnings growth. While global stocks, particularly in growth sectors, have had a tremendous run in the past 2½ years, the chart below shows how the gains have been driven more by higher valuations than earnings growth. The study by Thomson Financial illustrates that the MSCI World Index is up by 41% since the beginning of 2012. However, 36 of the 41 percentage point gain has been driven by an expansion in the price-earnings multiple while only 5 percentage points can be attributed to earnings gains. This is not completely unusual since interest rates are at all-time lows, which supports a higher valuation for stocks and economic growth is expected to pick up, thereby providing better earnings growth. But investors should get more worried as stocks continue to rise on ‘hope and air’, as opposed to stronger growth.
Despite how the stock market has gotten to where it is, the combinations of stocks moving to new highs while housing is also in a recovery mode has pushed Household Net Worth in the U.S. back near the highs seen before the collapse of the housing market in 2007. The chart below, put together by Bank of America with data from the U.S. Federal Reserve, shows Household Net Worth at 640% of disposable income, not far below the 660% level seen in 2007. Higher wealth levels generally get translated into higher consumer spending (historical data shows this ‘wealth effect’ at somewhere between 5-10% of net worth), suggesting some support for economic growth going forward, provided of course that interest rates remain as accommodative as they are currently.
Second quarter earnings reporting season wound down in early August but then the Canadian banks reported their 3rd quarter earnings (for period ended July 31st) late in the month. Expectations were for flat quarter-over-quarter earnings growth and an annual growth of about 10%. However, all of the banks beat expectations with strength in their ‘commercial’ businesses showing the greatest gains. This came from strength in capital market revenues such as trading and investment finance, which is not always given a high valuation due to its volatility from quarter to quarter. So with earnings quality down a notch, investors were booking gains that incurred before the reporting season and selling into strength. Bank stocks have also moved to the higher end of their earnings valuation range as we’ve seen the forward PE of the Canadian bank index move to 12.4 from 10.4 a year ago, a 20% increase. Over the past 20 years the bank index has traded at an average PE multiple of between 9.8x (at the 2009 market lows) and slightly over 14x (in 1998 during the peak of the ‘bank merger frenzy’ when the government finally stepped in and blocked a proposed merger between CIBC and TD Bank). However, on a dividend yield basis, the 4% average dividend yield of the Canadian banks compares very favourable with the 2% yield on 10-year government bonds. So once again, extremely low interest rates provide the best support for stock valuations.