Stock market index S&P 500 in the US gained about 30% in 2013, one of the best years for US equities in recent times. The rally in the US market was supported by the improving fundamentals of the economy. The US economy expanded at a healthy rate of 4.1% in the third quarter of 2013. But this is only one part of the story. The cyclically adjusted price-to-earnings ratio (or the Shiller P-E) for the S&P 500 is above 25 compared with the historical mean of 16.5. This simply means that stock prices have gained more than the earnings would have warranted.
In fact, as The Economist recently highlighted, the profits for corporate America went up by $39.2 billion in the September quarter compared with a rise of a $66.8 billion in the previous quarter (see: Solving the puzzle, The Economist, 4 January 2014).
The London-based newspaper also noted: “The big gains of 2013 were caused by investors re-rating the equity markets rather than because of the profit fundamentals.”
What is re-rating?
Re-rating in the stock markets simply means that investors are willing to pay a higher price for shares, usually in anticipation of higher earnings in the future. What re-rating of shares does is that it expands the P-E ratio. Here is an example. If shares of company A are trading at Rs.100 per share with earning per share at Rs.10, it also means a P-E of 10. But if the share price shoots up to, say, Rs.200 and the earnings per share also goes up to Rs.15, the new P-E will be 13.3, which is higher than the 10 in the previous period. If the market is willing to pay a higher price compared with earnings for the shares of company A, it will be termed as re-rating of shares by the market.
This re-rating, or expansion in valuation, can happen for a company, or for the entire market, due to a number of reasons such as improvement in the demand situation, pick-up in the general economic activity or favourable policy decisions.
Interestingly, the expansion in the valuations in the US has happened at a time when the growth in the profitability of companies there is expected to moderate. Therefore, it is possible that, more than the earnings growth, it is the easy availability of money that is driving the stock prices.
Though the US Federal Reserve has decided to reduce the pace of its asset purchase programme, it will still be buying assets worth $75 billion per month from the marketplace and is expected to keep its policy rates near zero in the foreseeable future.
The India story
The S&P BSE Sensex in India is trading at a P-E of 17.75 compared with its 10-year average of 18.42. The P-E expanded in January 2008 to over 27 as it was argued that India with its high growth deserved higher valuations. But such high valuations could not be sustained due to the global financial crisis followed by the problems in the domestic economy.