The best, most promising kind of equity market rallies are those when stock prices are racing to catch up with improving profit outlooks. We are not in that kind of rally. Earnings growth is extremely weak, which means that so far, there is no recent fundamental underpinning for recent equity market strength on either side of the border.
The trend is the same in Canada and the United States as markets continue to climb with little in the way of earnings growth. The "P" in the price to earnings calculation is heading higher while the "E" has either declined or remained flat. The result is a price-to-earnings ratio for the S&P/TSX composite of 22.3 times – four points higher than the five-year average of 18.3 times – and an S&P 500 P/E ratio of 20 relative to the five-year average of 16.6. This process is called multiple expansion – the market rising at the expense of price-to-earnings ratios.
With regards to U.S. equities, David Kostin, chief U.S. equity strategist at Goldman Sachs, believes that the period of multiple expansion is over and weak earnings will soon be reflected in stock prices. "[T]he S&P 500 forward P/E has already expanded by 70 per cent during the past five years, exceeding all other expansion cycles except 1984-1987 (up 111 per cent) and 1994-1999 (up 115 per cent). Both prior extreme P/E multiple expansion cycles ended poorly for equity investors."
Mr. Kostin goes on to note that valuation levels are already at historical extremes and this is not at all supported by near-zero or negative profit growth. The first chart, below, shows the dramatic extent to which U.S. stock prices have outdistanced earnings growth.
Goldman Sachs also cites the negative effects of extremely low interest rates on bank profits, and that leads us to the Canadian equity market. Along with energy and mining, domestic financials dominate the performance of the S&P/TSX composite. Not only are domestic banks dealing with low interest rates, record household debt levels suggest that lending activity is set to slow. A darker outlook for domestic bank profits makes current valuations in the overall domestic market look more precarious.
The second, lower chart shows that, by and large, the performance of the domestic equity market has followed the course of earnings growth. This was particularly evident in the time frame of March, 2015, to January, 2016, when a decline in earnings was closely followed by a significant downturn in stock prices.
The S&P/TSX composite, like the S&P 500, is ahead of where earnings suggest it should be after the rally began on Jan. 15. The benchmark leaped 20 per cent while earnings were up by a far smaller 5.8 per cent.
Importantly, the profit numbers in the charts are backward looking and markets always look forward. Investors in the United States and Canada are clearly expecting an improvement in the profit outlook, which in Canada could feature resilience in bank profits, higher commodity prices, or a jump led by industrial exports.
But the investment risks in the event that profits don't improve, as Mr. Kostin expects, are significant and stock prices have a good distance to fall to reflect current earnings fundamentals.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online.