Money managers aren't so different from individual investors.
They're always trying to figure out if stocks are expensive... or if they've discovered an imbalance in valuations ahead of everyone else.
After all, the name of the game on Wall Street is performance relative to expectations. You want to find the deals no one else sees. But as today's market shows, it's important to look at this in the right way.
Wall Street's best are always trying to look at where the economy and the market are headed... not where they've been. Consequently, they're looking at least six to eight months out.
Meanwhile, the financial media gets caught up in the "here and now." That confuses individual investors, because it's the opposite of how they should be thinking. And right now, it's causing lots of folks to miss the opportunity in the market.
Let me explain...
If we were to get caught up in the "here and now" thinking of the media, we'd look at the S&P 500 Index's current valuations. The current multiple of 22.16 times earnings is worrisome. But it's also a look in the rearview mirror.
If we look at the same index's valuation from a forward 12-month perspective, like asset managers, we'd see it sits at 18.9 times earnings. (In other words, that's what you get if you base it on the expected earnings over the next year.)
Now, some would argue that's still expensive. But it's much more reasonable than the current multiple. And if we look out two years, we'd see a 17.2 times multiple... while in three years, it's just a 15.5 times multiple. Take a look...
This tells us that analysts expect earnings growth to pick from here. And based on those expectations, the market looks even cheaper than most realize.
The next question we have to ask is, are these future earnings estimates reasonable?
Based on what we know, they're more than reasonable... They're too low.
Coming into the last two quarters, Wall Street analysts lowered their earnings estimates. Heading into the third quarter of 2019, analysts were pessimistic again – they predicted a decline of 4.6%. (The actual figure came in at a drop of 2.3%.)
This past quarter was no different. At the beginning of the fourth quarter, Wall Street stock pickers started out expecting 2.5% earnings growth. Those expectations have since dropped to a decline of 1.9%. With all the negativity we've seen from analysts, the actual result may be closer to unchanged or slightly positive.
It's easy to see why they became so cautious... A big driver was the perilous state of trade negotiations between the U.S. and China. No one knew what the costs would be or how the tariffs would affect consumer spending.
Companies haven't helped. Given the uncertainty around trade, they've been cautious about their business outlooks, too. They didn't know if they would have to uproot their manufacturing processes and move them to other countries.
The safest bet for both corporate America and analysts everywhere was to expect the worst. Consequently, numbers more or less came down across the board. And as earnings numbers dropped, it pushed the valuation multiple of the S&P 500 Index and other indexes higher.
That's why stocks are cheaper than anyone believes today. Estimates have come down based on problems that are now largely in the rearview mirror. Looking ahead, the picture is much brighter than folks expect.
The U.S. and China just signed the phase one trade deal, which should cause tension and uncertainty to ease. Companies now have a better handle on what their costs are going to look like.
As a result, the corporate guidance that was based on the worst-case scenario can change. And that should provide continued support for the S&P 500.
It's one more reason why staying bullish is the right call today.
C. Scott Garliss
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