Where's the upside?

Seven years into this bull market, how is it that equities continue to rally? I share investors' scepticism, but not because of the duration of the bull market or the size of the rally. I struggle to find reasons to be bullish on the two fundamental drivers of equities: earnings and valuations.

Seven years into this bull market, with the S&P 500 up 260% in total return terms, it’s perhaps not surprising that many investors are struggling to see where another significant leg-up for equities could come from, at least in the short term.

 

I share this scepticism, but not based on the duration of the bull market or the size of the rally. What worries me is that I struggle to find reasons to be bullish earnings and valuations:  the two fundamental drivers of equities.

It’s difficult to see US earnings growth rebounding back into double digits for more than a couple of quarters

While I don’t share the bears’ views that we are witnessing the beginning of a traditional cyclical earnings recession, I also find it difficult to get excited about the upside in earnings growth. Our economists expect global growth to remain at or slightly below trend, putting a cap on sales growth. With US margins already close to record highs, our macro models suggest low to mid-single digit earnings growth as a base line of what to expect. Earnings growth is clearly running below that at the moment, depressed by commodity price weakness and lower-than-expected global growth, but even if those headwinds were to fade it’s difficult to see US earnings growth rebounding back into double digits for more than a couple of quarters.

It’s always possible to construct a scenario where equities would rise 10% over the next year, but getting there requires more and more aggressive assumptions; too aggressive for my taste

Valuations offer a more realistic path to stronger equity returns. By and large the broad range of valuation metrics I track are in somewhat (but not extremely) expensive territory, a headwind rather than a real concern. But equities have not re-rated on the back of record low bond yields, so arguably they are cheap compared to what else we could buy. Though not our base case, this could still happen. The even more dovish than expected recent comments from the US Federal Reserve and the European Central Bank’s buying of corporate bonds can only have shifted the odds of low fixed income yields spilling over into equities. I’ll be keeping a close eye on any signs that equity dividend yields are starting to fall.

 

The table below is a useful reality check of both these components of equity returns. You can choose your combination of what S&P 500 earnings per share (EPS) and price-to-earnings (PE) ratios will be at the end of this year to see what upside that implies from today’s S&P 500 (2,100) as a starting point. The highlighted range shows 2015 EPS and the PE ratio range of the last few years.

It’s always possible to construct a scenario where equities would rise 10% over the next year, but getting there requires more and more aggressive assumptions; too aggressive for my taste. That doesn’t mean we’re heading for an imminent sell-off, but the air for further upside is getting increasingly thin.

 
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