Rising yields may take the shine off an earnings boost

There is little doubt on Wall Street that U.S. corporate profits are on track to rise at a healthy rate this year, with an overall estimate for growth of almost 20%.

Less certain, however, is how investors should value those profits with price-to-earnings estimates. The struggle to do so could lead to more stock market volatility.

The valuations issue has gained fresh prominence for market strategists amid a rise in interest rates and bond yields, along with concerns about inflation increasing.

Ageing bull market

Those factors, including a yield on the benchmark 10-year U.S. Treasury note that is approaching 3%, has prompted investors to rethink how to price stocks,which have become more expensive as the nearly nine-year bull market has aged.

Indeed, some investors are weighing whether equities deserve lower valuations.

“Its a topic that’s got to be in the front of a lot of asset managers’ minds right now: What level is this market a really good buy again?,” said Jim Paulsen, chief investment strategist at The Leuthold Group.

“We are going to get good earnings coming through,” Mr. Paulsen said. “The problem is we are going to lose the value on those earnings.”

A test for equity valuations could come with next Friday’s U.S. employment report for February. Last month’s report revealed surprising wage gains that sparked concerns of inflation, in turn setting off a jump in yields and a drop in stocks.

Stocks are commonly valued by comparing their price to their estimated profits over the next year, known as the price-to-earnings, or P/E, ratio.

Interest rates set the discount for what you want to value companies at and in general with higher interest rates you are going to see lower P/Es as fair value, said Rick Meckler, president of LibertyView Capital Management. “You are going to be less willing to pay higher multiples on stocks where your discount rate continues to go up.”

The P/E ratio on the benchmark S&P 500 index had climbed to 18.6 times by the end of January, the highest level in about 15 years, according to Thomson Reuters Datastream, as stocks climbed to all-time peaks.

That was just before the market plunged at the start of February, dropping 10% and confirming a correction, and in turn lowering the P/E ratio to 17 times earnings estimates.

Valuations hovered around that level at the end of a turbulent week. The S&P 500 rose 0.5% on Friday, recovering some losses from Thursday, when U.S. President Donald Trump announced plans for tariffs on steel and aluminium, raising concern about higher prices and a trade war.

‘Repricing of assets’

“A lot of the volatility that has occurred and a bit of the repricing of financial assets, stocks in particular, is a result of there [being] a little bit of uncertainty as to what we should use as that discount rate,” said Michael Arone, chief investment strategist at State Street Global Advisors.

Half of the S&P 500’s returns last year stemmed from the P/E going up — investors willing to pay more for future earnings — helped by optimism about the global economy, according to Mr. Arone, but people’s willingness to “pay even more for those earnings is probably beginning to fade.”

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