On paper, stocks look like bargains in the wake of their recent selloff. The question is whether, given the latest threats facing the market, those cheap valuations are worth the paper they're written on.
On Monday, stocks extended their recovery from the two-week plunge in late July and early August that shaved 14 per cent off the S&P/TSX composite and 17 per cent off the U.S. benchmark S&P 500, as investors continued to be drawn back to the market by what look like highly attractive stock valuations.
Even with the gains of the past few sessions, the S&P 500's "forward" price-to-earnings (P/E) ratio based on earnings forecasts for the next 12 months is around 12 times, well below the historical norm of about 15 to 16 times.
"[The recent market slide] did leave the valuations looking more attractive," said George Vasic, chief strategist at UBS Securities Canada Inc.
However, the current circumstances suggest that valuations need to be taken with at least a grain of salt, if not a spoonful or two.
The slowing economic outlook has made earnings forecasts highly questionable, market strategists warn. Meanwhile, the possibility of another recession or global financial crisis has elevated investors' sensitivity to risk and weighed on what they are willing to pay for returns.
"The depressed P/Es are depressed for a reason – they should be depressed," said Mr. Vasic.
"For some pundits, forward earnings are meaningless, as they are likely to be revised down in the coming weeks as slow growth takes its toll on profits," said Stéfane Marion, chief economist and chief strategist at National Bank Financial in Montreal.
David Rosenberg, chief economist at Gluskin Sheff, said in a note to clients Monday that if the U.S. were to fall into a "garden-variety recession," the typical slowdown to the earnings outlook that would follow "would mean that the [market's] forward [P/E] multiple is closer to 16 times" at current levels.
Citigroup equity strategist Tobias Levkovich said that the typical decline in earnings expectations in a recession is about 25 to 30 per cent. That would imply a fair value for the S&P 500 in the case of another recession of about 1,050 to 1,200 based on a "normal" P/E multiple of 15 to 16 times. Those numbers suggest the S&P 500 has largely priced in the risk of another recession.
"Barring a credit implosion and some form of global economic meltdown, stock prices at current values seem very reasonably priced," he said in a report last week, when the S&P 500 had slumped below 1,120.
But many analysts find the use of forward P/Es problematic, especially around turning points in economic cycles, when forecasting becomes unreliable. In recent years, the use of cyclically adjusted P/Es (sometimes called "normalized" or "smoothed" P/Es), which use an inflation-adjusted 10-year average of earnings, have become increasingly popular for gauging market valuations.
Mr. Rosenberg said that on this basis, the P/E for the S&P 500 is at 20.3 – "still above the 19.4 average, and four points higher than what is typical for a recession trough."
Mr. Marion of National Bank Financial argued that risk elements are depressing stock valuations generally – and these lower valuations may be more than just a temporary phenomenon. He said investors have been "re-pricing risk" over the past few years, because of the perception of higher volatility in stocks, coupled with an aging investor base more focused on retirement.
That, he said, could mean that the long-standing "normal" levels for P/E valuations no longer apply.
"I do think there is room for some multiple expansion" at current market levels, he said, but he added that a "fair" valuation in the future may be more like 12 times than 15 times. "What we've seen in the past 30 years may be too pricey."
David Parkinson