One of Peter Lynch’s Top Metrics Shows Stocks Getting Cheaper

  • PEG ratio has fallen over last two years despite equity gains
  • Analysts are bucking 7-year trend and raising profit forecasts
UBS Head of Global EM Strategy Geoffrey Dennis calls the move higher in equities "earnings-driven."

By virtually any measure, U.S. stocks are expensive. Under one especially harsh lens, the cyclically adjusted price-earnings ratio popularized by Robert Shiller, equities relative to 10 years of profits are more stretched than any time in a century, save the dot-com era.

But there’s still a methodology that bulls can take comfort in -- price not just to earnings, but to earnings growth. Favored by legendary investor Peter Lynch and known as the PEG ratio, the technique takes the standard valuation snapshot and adds time -- time for a stock to grow into its price.

If you’re a bull in 2018, you’re probably making an argument that at least glances at this logic. By the standard tools, companies trade for 23 times earnings. But those earnings are increasing: analysts forecast per-share profit in the S&P 500 will rise 15 percent in 2018, the fastest clip since 2011. They expect growth to approach 13 percent a year through 2023, data compiled by Yardeni Research Inc. and Bloomberg show.

Incorporating that, stocks can actually be framed as getting cheaper -- even with the S&P 500 sitting 47 percent above its February 2016 low. While the current 1.43 PEG ratio still exceeds the average of 1.24 since 1985, it’s down from a record 1.72 in early 2016 and trails readings during four distinctive periods.

The data may be one reason why stocks continued to rally, defying forecasts that elevated valuations means muted returns. The S&P 500 has risen every day this year, building on the best annual gain since 2013 amid expectation that a pickup in profit growth will help alleviate pressure from stock multiples.

Peter Lynch

Photographer: Michael Springer/Bloomberg

“Yes, markets are arguably expensive by history, but this environment of accelerating not only earnings but also economic strength is what’s catching the market’s attention right now,” said John Augustine, chief investment officer for Huntington Private Bank that oversees $18.4 billion at Columbus, Ohio.

This year marks the first time since 2010 that analysts raised earnings estimates heading into a new year. Their combined per-share profit forecast for S&P 500 companies has increased by $3.20 to $148.30 since the end of September, bucking a seven-year trend of downward revisions at this time.

Earnings Optimism

Analysts raise estimates for the first time since 2010 heading into a new year

Source: Bloomberg

Upgrades will continue for the rest of the year as analysts wait for the benefit from December’s tax cuts to kick in, according to Jonathan Golub, Credit Suisse Group AG’s chief U.S. equity strategist, who estimates the boost in estimates so far is only “a fraction of the likely impact.”

Another factor to dismiss the ominous message from the CAPE ratio: this is the year when 2008, a period of horrendous corporate profits, drops out of the 10-year range the valuation tool uses to calculate the numbers. According to Michael Regan, lead blogger of Bloomberg News’ Markets Live, the calendar alone would theoretically pull CAPE down by somewhere in the neighborhood of 10 percent over the next two years.

Such a view was echoed by an economic letter released Monday by Federal Reserve San Francisco. Current high readings in 10-year P/Es reflect weak earnings during the global financial recession and subsequent recovery, wrote Patrick Shultz and Michael Tubbs of SF Fed’s economic research department. “Recent data suggest a less bearish outlook than one would expect” for stocks, they said.

Ed Yardeni, the founder of his namesake research firm, says that while a drop in the PEG ratio may offer some comfort for equity bulls, it’s worth noting that the decline is accompanying higher P/E multiples as well as earnings expectations. Just as higher valuations can be seen as growing investor optimism, rising profit forecasts shows analysts are turning more bullish.

“CAPE tends to be too pessimistic and PEG may be too optimistic,” Yardeni said by phone. “The truth may lie somewhere in between.”

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