Can stocks grow into their price-to-earnings multiples? Can enough happen to make stocks cheaper than they seem?
That's what is going to have happen to justify these prices now that earnings season begins in earnest.
What do I mean by "growing in" to the P/E multiple? Right now we are paying a great deal for future earnings. People like to use the P/E multiple of the entire market to judge if it is too expensive. At 22x earnings there is no question that the market is too expensive. I typically don't even care for a market with a P/E multiple north of 19. Historically that's where you tend to get in trouble.
We should never have gone this high. It is reminiscent of the heights we reached before the Super Bowl in 2018, when inflation came in too high after the February employment number and the whole complex of VIX short sellers, those who bet that VIX would stay calm no matter what, got their heads handed to them. They needed to unwind their positions, which included selling the S&P 500 futures and crushed the market -- which was easy to do, like now, with stock way past where they should be at this stage.
So what can justify why you are paying so much?
First, earnings have to be better than expected. That was the case with the banks, when big fund managers simply stopped caring about the net interest margin and focused on stability. JP Morgan (JPM) put up a consistently great number that made its 13x multiple look too cheap. That said, the stock failed to go higher, it simply didn't go down, giving it a lower multiple to a newfound earnings model. It sells at just 12x earnings. Goldman Sachs (GS) delivered a consistent number when we expected inconsistency. That, plus an end-of-the- month analyst meeting, gave conviction that it was okay to pay 10x earnings.
Oddly, the biggest, winner, Morgan Stanley (MS) , still sells at the same P/E, 10x, even after it reported a truly colossal quarter and jumped up five points. My only conclusion: These better-than-expected earnings simply kept the stocks in place. Usually better-than-expected lifts stocks. This earnings season, it's kept them from going down. That's a sign that we are paying too much.
Second justification: mergers and acquisitions. If we see companies buying other companies, that's a sure sign that the P/E can be justified and we aren't paying up too much. We had a big party of M&A at year's end. But the first sixteen days are fallow.
Third, big dividends and buybacks. We chronically misjudge or don't care about either of these. That's a big mistake. Citigroup (C) has retired a third of its outstanding shares. As long as it is around book value, CEO Michael Corbat will cull another 8% of the stock. They have been an immense floor under the stock, which has worked remarkably well.
Meanwhile dividend boosts are a tremendous source of strength that's derided or ignored. Yet, you are making a mistake, as Action Alerts Plus did when we sold the stock in the low $140s. People love that dividend.
Fourth, the tariff lift has caused underperforming stocks to start outperforming. There is no doubt that the tariffs hindered business. The hope is that investors will see through to the end of tariffs, allowing earnings to blossom. Therefore, we have to believe that the huge exporters will do better.
Five, finally we have to have another leg down in yield to keep the higher dividend-yield stocks from collapsing. In many ways, this is the one I am most worried about: a wholesale decline in the price of the bonds. It can happen. It's a good thing that the dollar's been weak -- something that helps earnings -- but if we lose the incremental money that comes in to keep yields lower, then we will be paying too much given that rates are so crucial to determining price.
We need several of these five to stay where we are. We need all five to advance. If we get none of these, we are going lower, perhaps much lower.