Dividends and earnings growth get all the attention, but margin expansion – stock prices rising even though profits remain at same levels – is equally important as a source of equity market returns.
On this front, we have good news. Adam Parker, chief U.S. equity strategist at Morgan Stanley, recently noted that price earnings multiples and stock prices historically rise with inflation-adjusted (real) interest rates. This trend suggests significant upside for U.S. stocks even if profit levels stagnate.
This chart shows real U.S. ten-year yields plotted against the trailing price to earnings multiple for the S&P 500. The closeness of the relationship is uneven and the correlation is 0.54 using monthly data from 2000.
Nonetheless, it is clear that Mr. Parker's observation is valid – multiples have climbed along with inflation-adjusted bond yields.
For U.S. equity investors, the stakes here are high. The S&P 500 currently trades at 16.7 times trailing earnings. If the price earnings multiple rises to 18 times, this implies a 7.5 per cent appreciation for the benchmark. Remember, this potential gain is based on multiple expansion alone. The 7.5 per cent gain would happen without any earnings growth.
The potential end of a 30 year bull market in bonds makes margin expansion more plausible. Investors are likely to rotate out of bonds and into equities as yields move higher.
Mr. Parker's somewhat surprising findings should embolden investors in U.S. stocks who are concerned about slower sales growth and meagre gains in year over year profits. Rising real rates provide a significant and possibly lucrative tailwind to U.S. stock prices.
To view the chart on mobile devices, click here: http://bit.ly/1bSKlHu
Scott Barlow