2017 has undoubtedly been a year of market oddities, one that ended with the bitcoin valuation hockey stick chart finally running up against resistance to end the year. But outside of assets that have little tangible value also stand several oddities in the stock market, among them volatility. Valuations bucking up against all-time highs comes at a time when an increase in market volatility could dramatically change that equation. Looking at SP 500 returns for 2017 with an eye to 2018, a Credit Suisse report points to factor outperformance amid P/E multiple contractions.
P/E multiple contractions after strong SP 500 2017 returns: Higher P/E levels have historically indicated challenging markets
Over more extended periods of time, higher price-earnings ratios have led to lower profits, the report noted. Don’t tell that to SP 500 stocks in 2017, which returned near 20% for the SP 500 while P/E ratios were at some of their highest levels in history. In fact, during 2017, and an unpredictable Trump administration run, not a negative stock market month was visible in the year, a statistical oddity in a year of unusual developments.
Credit Suisse attributed large-cap outperformance to multiple expansion – a move that in some circles is considered taking returns from future years – and stock buybacks, a favorite corporate move when extra cash is prevalent. The move higher was not attributed to this year’s actual earnings.
Earnings per share are expected to grow 17% in 2018, Credit Suisse estimates, while the stock market might move higher by 12%, with the SP 500 hitting the 3,000 level, pointing to an introversion of this EPS spread and catching up between P/E levels and earnings per share. Credit Suisse predicts a 5% P/E contraction in 2018.
As the acceptable price earnings ratio on stocks pushes the 18.4 level – a notable standard deviation away from its long-term average – there exists a lack of market volatility that, likewise dragging near historically low levels that center near 11.2.
P/E multiple contractions for SP 500 returns for 2017: If multiples rapidly contract, what happens to volatility?
While the forward price earnings ratio has a history of mean reverting after peaking above the 1st standard deviation benchmark, the same modeling doesn’t precisely apply to volatility. Volatility most visibly rose in 2008, a point in time when P/E ratios mostly meandered below their 14.3 average.
Low volatility was a key factor contributing to all-time highs. Sixty-two trading days in 2017 featured low volatility days at a time when all-time highs were hit. This is a historical oddity and a significant move past the long-term average of 16 low volatility days resulting in all-time highs.
In this P/E multiple environments, it was factors based on earnings per share that outperformed.
Among the leading factors in SP 500 returns for 2017 were Earnings Per Share, up 24.7%, and EPS Revision stocks, up 22.6%. All other factors underperformed the broad S&P 500 benchmark, up 21.8%, with 12-month momentum the third top performer at 21.7%.
While SP 500 returns for 2017 might be considered the year of tax reform in Washington DC, the High Tax Rate stock factor bucket was actually 9th on the performance list, delivering 17.6% returns, and just 5 spots from the bottom.
Going into 2018, a year of expected P/E multiple contractions, Credit Suisse likes Financials, Technology and Discretionary stock sectors, while Energy, Utilities, Telecom, and REITs are underweight in their models.
The yield curve spread between the US ten year, and two-year interest rate products have been trending lower since 2008, marking lower highs. The pattern is entirely different from the 2005 and 2006 period when the “TUT” spread quickly bottomed and then recovered on a dime, a mean reversion pattern that was not often seen on a historical basis.
SP 500 returns have been most robust when the yield curve is flat or steep by 100 basis points. The current yield curve stands at 50 basis points. When the curve is inverted stocks perform their worst, on average up 5%. When the curve is abnormally steep, the are up on average 7.9% and when in the sweet spot between flat and steep by 100 basis points stocks perform significantly better, up 13.3%.