(Updates with latest trading, U.S.-China trade developments, paragraphs 7, 8)
By Lewis Krauskopf
NEW YORK, May 10 (Reuters) - Stock valuations have climbed to levels reached just before Wall Street's late 2018 plunge, leaving the market at risk of shocks such as the sell-off this week as global trade tensions mounted.
But stocks may have more support than last year, due largely to lower bond yields and a more dovish outlook on interest rates from the Federal Reserve.
Under the traditional price-to-earnings (P/E) ratio method of valuing equities, stocks recently rose to their most expensive level since September. The benchmark S&P 500 index peaked last year on Sept 20, before sliding nearly 20% over the next three months.
The forward P/E for the index, which compares stock prices to estimated earnings over the next year, had climbed recently to 17 times, making the index about 13% more expensive than its historic average, according to more than 30 years of data tracked by Refinitiv.
"Whenever you get up to these levels, you just become more vulnerable," said Matt Maley, equity strategist with Miller Tabak. "We know that valuations can stay high for extended periods of time, but it does make the market vulnerable to new negative developments and that is kind of what we are seeing this week."
After the S&P 500 hit record highs last week, U.S. President Donald Trump spooked stocks by threatening over the weekend to raise tariffs on Chinese imports. This ratcheted up tensions in the long-running trade dispute between the world's two largest economies. Investors who had been optimistic about a U.S.-China deal now worried that such a deal may not happen anytime soon.
The S&P fell early on Friday but finished slightly higher after remarks from Trump and other officials fed hopes that Washington and Beijing would avoid the worst-case scenario of a complete breakdown in negotiations.
As of Friday's close, the S&P 500 was about 2.2% below its all-time high close, which in turn reduced the forward P/E multiple on the S&P 500 to nearly 16.8 times, still well above the historic average of 15.1 times. On Friday, the S&P 500 rose 0.4%.
“The margin of error is thin based on the reaction we have seen to some of the rhetoric from the U.S.-China trade agreement,” said Michael Arone, chief investment strategist for State Street Global Advisors.
Debate about valuations has taken hold broadly. Just this week, the Fed called stock prices "elevated" in its latest financial stability report.
Stocks may have a cushion, however, with lower interest rates, which help the allure of stocks.
The yield on the benchmark 10-year U.S. Treasury note sits at 2.46%, after eclipsing 3.2% in November, making bonds look less competitive as an investment versus equities. Stocks are typically valued through by estimating their future cash flows, which are more valuable at lower rates.
The Fed, meanwhile, has signaled little appetite to adjust rates any time soon. As recently as December, the Fed had anticipated further rises in borrowing costs in 2019.
“The biggest difference is the pivot by the Fed," said Chuck Carlson, chief executive officer at Horizon Investment Services in Hammond, Indiana. "In a low interest-rate environment, if that persists, you can have higher multiples because you have more demand because you can’t make any money anywhere else other than equities. It’s the classic risk-on (trade.)”
Jonathan Golub, chief U.S. equity strategist at Credit Suisse, issued a report this week, titled "The Case for Much Higher Valuations". It contended that by comparing prices to company cash flows, stocks are actually trading at a 20% discount to their historic averages.
"If you simply look at forward price to earnings, it would suggest the market is roughly fairly valued or maybe even a little bit expensive,” State Street's Arone said. But, he added, "other measures might suggest the market is actually undervalued."
Even with this week's pullback, the S&P 500 is up 22.6% since Dec. 24, when the index posted its lowest close since April 2017. But earnings estimates for the next 12-month period have only climbed 1.5% over that time, according to Refinitiv data.
So the market's surge is almost entirely due to valuations expanding, after the P/E fell as low as 13.9 times on Dec 24.
That imbalance leads some market watchers to say that any significant leg higher for stocks rests on the earnings picture improving, as opposed to valuations going even higher.
As it stands, earnings growth is expected to pick up later in the year, with fourth-quarter S&P 500 profits seen rising 8.1% after increases of between 1.2% to $1.8% in the first three quarters, according to Refinitiv. Annual earnings are expected to rise 11.7% in 2020 compared to this year.
But a collapse of U.S.-China trade discussions could darken the earnings outlook. Investors expect tariffs could increase corporate costs and lower profit margins, while persistent uncertainty surrounding a trade deal will hinder the ability of companies to plan or make capital expenditures.
"A lot of people have been putting their estimates together for the second half based on a near-term positive outcome on this trade deal," Miller Tabak's Maley said. "If that gets pushed out further, that gets earnings pushed out further, and that makes valuations more stretched.” (Reporting by Lewis Krauskopf; Editing by Alden Bentley and David Gregorio)