Wall Street has been understandably preoccupied over the past few weeks with events in Washington, especially the painstaking negotiations on the so-called fiscal cliff.
But beneath those murky political clouds, equities appear to be far from overvalued.
In fact, price-to-earnings ratios for both trailing and projected earnings suggest the S&P 500 may be trading at a hefty discount of as much as 23%, according to new research from S&P Capital IQ.
If Washington is able to avoid a doomsday scenario on the fiscal cliff, P/E ratios could rise to historical norms, sending the equity markets surging through all-time highs set weeks before the Great Recession began in late 2007.
“We believe misplaced investor fears are unjustly compressing multiples in the current environment, something we expect to reverse as the economy continues to grow, albeit at a moderate rate,” Brian Belski, chief investment strategist at BMO Capital Markets (NYSE:BMO), wrote in a note to clients this week.
P/E Ratios Look Cheap
According to McGraw-Hill’s (NYSE:MHP) Capital IQ, heading into this week the S&P 500 traded at just 13 times projected 12-month earnings of $108.56 per share, compared with the median multiple of 16 going back to May 1998.
The benchmark index would need to surge 23% from Friday’s close at 1413.58 just to reach that historical multiple. Such a burst of buying would leave the S&P 500 at about 1740, 11% past the index’s all-time closing high of 1565.15.
Ed Yardeni, president of investment advisory Yardeni Research, predicts a done deal on the fiscal cliff could drive the markets beyond record closing highs even before the end of the year.
“Then we can all believe in Santa Claus and his year-end rallies,” Yardeni wrote in a note to clients.
While there is an understandable reluctance to buy into Wall Street’s estimates for projected profits, equities may even be cheap from a trailing earnings perspective.
The S&P 500 closed out last week with a trailing 12-month operating P/E ratio of 13.9, a 22% discount to the median ratio of 17.9 since 1988, Capital IQ said.
Likewise, based on GAAP earnings, the S&P 500 is trading at 16.3 times trailing earnings, 20% below the historical P/E ratio of 20.8, analysts said.
“Even though the Presidential and Economic Cycles may generate threatening downdrafts to this already low-flying economic recovery, valuations -- based on backward and forward, operating and GAAP EPS -- appear to us to be offering some offsetting uplift,” Sam Stovall, chief investment strategist at Capital IQ, wrote in a research note.
Inflationary Jitters Overdone?
Some fear that the Federal Reserve’s unprecedented efforts to flood the financial system with cash will set off a wave of inflation, which tends to be a large negative for equity P/E ratios.
According to Capital IQ, since 1948 the S&P 500 traded at its lowest average multiple of 10 in quarters where annual consumer price growth was at a painfully high level of 5.5% or more.
However, last week the Labor Department said consumer prices rose just 1.8% year-over-year, far from those scary inflationary predictions.
Capital IQ said that the S&P 500 has enjoyed a 12-month trailing multiple that is close to 20 when inflation is comfortably in the 1.5% to 2.6% zone, compared with its current level of 16.3.
If these valuations are proven to be cheap, it wouldn’t be the first time bullish or bearish investor sentiment became exaggerated before major events, such as at the heights of the dotcom and housing bubbles or during the depths of the 2008-09 financial crisis.
Investors tend to display this “paranoia, confusing the hiccups for heart attacks,” Matt Lloyd, chief investment strategist at Advisors Asset Management, told FOX Business.
Rosy Outlook Contingent on Cliff Deal
Of course, the flipside to this argument is that stocks could turn out to be vastly overvalued if the U.S. falls off the fiscal cliff, the $600 billion package of spending cuts and tax increases set to take effect if Congress can’t reach a compromise.
According to a risk analysis released last week by SunGard’s APT, if a decision on the fiscal cliff is delayed by one month, the S&P 500 would likely tumble 15% from December levels and shares of banks like Citigroup (NYSE:C) could dive 25%.
An unlikely scenario where a stalemate in Washington persists for six months would spark a painful 25% selloff for equities and a 35% plunge for financial stocks, APT projected.
Still, there are some signs Congressional Republicans and the White House are making progress on a potential budget deal that would call for roughly $1 trillion in spending cuts and about $1 trillion in new revenue.
Reading the tea leaves in Washington, the Dow Jones Industrial Average has soared as much as 225 points, or 1.7%, through the first two trading days this week.
“As it becomes more apparent that Washington will avoid the cliff and adopt a more sensible fiscal policy, risk-asset markets should respond positively,” analysts at Morgan Stanley Wealth Management (NYSE:MS) advised on Monday.