The Tell: When stock valuations are this rich, by this measure, returns in the next 12 months are meager

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Major stock benchmarks have picked up in 2020 where they left off last year, posting stellar gains, led largely by the consistent double-digit earnings growth for America’s largest companies.

But broader measures of the health of U.S. corporations paint a less optimistic picture, according to a Wednesday research note from Ned Davis of Ned Davis Research. He points to the Value Line Geometric index VALUG, +0.73%, an equal-weighted index that tracks the median performance of the roughly 1,700 largest U.S. corporations.

Not only has this index lagged far behind the S&P 500 index SPX, +0.52% —posting a 12-month gain of 3.2% versus the S&P 500’s 22.9% rise — its price to earnings, or P/E, ratio has still risen steadily, because aggressive stock buybacks haven’t been able to mask a worrisome trend of declining profits.

“The reason I lean toward technical, rather than fundamental analysis, is because I think stock prices are largely driven by liquidity and psychology, rather than fundamentals,” Davis wrote. “The last year is a good example of that.”

The Value Line P/E ratio is calculated using six months of trailing earnings and six month of forward earnings, then by taking the median valuation of its constituents to arrive at a clearer picture of the typical public company’s performance.

“Earnings per share last year (and for longer) were greatly boosted by buybacks. Yet, even with these buybacks, the P/E ratio moved up more than the price,” Davis wrote. “This means that fundamental earnings were down some 4%,” when excluding the impact of share repurchases.

Still, the price-to-earnings ratio has risen significantly since 2018, indicating that markets are moving higher on “psychology,” driven by what investors have seen as an accommodative Federal Reserve, which cut benchmark rates thrice in succession in 2019 to its current 1.50-1.75% range.

Unfortunately, when the Value Line P/E is above 17, as it is now, the S&P 500 has averaged just a 1.2% return over the following 12-month period, dating back to 1980, according to Davis. “Based up the historical record, this suggests stocks are likely to struggle until valuations come down,” he wrote.

To be sure, interest rates are much lower today than their average since 1980, which may support higher equity prices, all else being equal.

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