Let's start with the high prices. Weak earnings and relatively high prices have kept P/E multiples fairly high, and they're getting higher. At the end of October, the forward (2017) earnings multiple was 16.3. It's now moved up to 16.7, a significant expansion and near the highest levels all year.
Is the market worth the higher multiple? The most important determinant for an expanded multiple is the expectation that earnings will improve. The hope is that earnings will expand based on:
- Stronger economic growth — GDP just came in at 3 percent-plus instead of 2 percent. Particularly important is recent data indicating consumption in the third quarter was revised upward (from 2.1 to 2.85 percent) and consumer confidence is at nine-year highs.
- Significant fiscal policy stimulus in the form of tax cuts — Reducing the overall corporate tax rate to 15 percent from 35 percent would obviously have a big effect on earnings. But stock ownership could be more attractive as well by changes in individual taxes. Particularly important would be a repeal of the Affordable Care Act (with its 3.8 percent tax) and a reduction in the capital gains and dividend tax rates. "Reductions in capital gains taxes have been associated with increasing stock values and have benefited small caps over large caps," Daniel Clifton at Strategas said in a recent note to clients.
- Additional fiscal stimulus in the form of infrastructure spending.
- Fewer regulations.
Remember, earnings have already been improving. The third quarter saw earnings for the S&P 500 grow for the first time in four quarters.
Most importantly, the quality of earnings have been improving. For years, earnings growth has come mostly from cost-cutting, but top-line revenue growth has finally returned.
Revenues grew 2.6 percent in the third quarter, the first revenue growth in six quarters, according to Thomson Reuters. The fourth quarter will likely see revenue growth of 5 percent, but that could be significantly higher if oil companies see a boost with higher oil prices.
That's the hope for 2017 — that the top-line growth improves and with all the operating efficiencies companies have introduced that top-line growth will go straight to the bottom line.
That's what has the market so hyped up.
"We could absolutely get real earnings growth, as opposed to manufactured growth. I mean earnings growth that comes from higher revenues, not just cost-cutting," Jeff Solomon, CEO of Cowen, told me this morning.
If earnings really do expand in 2017, then a higher multiple — even 18 or 19 times forward earnings — could certainly be justified. But a lot depends on how much earnings expand. It hasn't happened yet.
The bottom-up (analyst) estimates for 2017 haven't really moved at all since the election. Analysts have not rushed to raise their estimates because they have no clue how to model tax cuts, stimulus programs and fewer regulations without specifics.
That has some saying that everyone should calm down.
"People are paying too much for stocks right now," Nick Raich from the Earnings Scout told me. "There is plenty of speculation that Trump will have a positive impact [on] the economy, but that is still speculation at this point."
He also notes the rally has been selective.
"There is no broad-based global rally. No overall improvement to earnings, at least not yet. Right now, I don't think multiple expansion is warranted."
One final point: If the primary determinant of higher multiples is expectations of higher earnings, why has the multiple been relatively high for the last several years, when earnings have been poor? It's largely because the Fed has forced so many people to stay in stocks. It's another reason stock purists have been mad at the Fed. They argue the central bank has distorted the stock market as well as the bond market.