How Wall Street Got It So Wrong On Stocks Last Year

By Bryan Rich

January 1, 4:00 pm EST

Remember, this time last year, the biggest Wall Street investment banks told us stocks would do just 3% in 2017.

They were looking for about 2,300 on the S&P 500. The most aggressive forecast was 2,500 — coming from the Canadian bank, RBC (Royal Bank of Canada).

Here’s another look at the snapshot of those projections for 2017:

They undershot by a lot. The S&P finished just shy of 2,700 for the year.  And S&P 500 earnings came in around $131. Wall Street was looking for $127.

But their big miss was underestimating the outlook for “multiple expansion.” The reason:  They continue to underestimate the demand for stocks, in a world where ultra-low yields continue to incentivize people to reach for higher returns (i.e. opt for the choice of more risk for more return).

Investors will pay more for each dollar of future earnings if they expect to earn a higher future rate of return. And they have expected just that over the past few years, because 1) central banks promised to keep pumping up asset prices through QE and to continue warding off any shock risks that could derail the recovery for the economy and stocks, and 2) we’ve had the major shift away from austerity, which has promoted a weaker than typical recovery out of recession (and worse, stall speed growth) and toward big and bold fiscal stimulus (one that can potentially return the economy to a more normal, higher long term growth rate).

That’s why the P/E on stocks can and should rise well north of 20 times earnings in this environment, just as it has over the past three years.

The P/E on the S&P 500 was 20 in 2015, 22 in 2016 and 23 for 2017 (on trailing earnings). In each case, we came into the year, with the market undervaluing earnings — given what people have proven to be willing to pay up for them.

The market is now valuing the New Year’s earnings at 19 times earnings.  And that ignores the probability that actual earnings can come in much better than estimates next year, given the corporate tax cut. That would ratchet down that “19 times” earnings valuation – making stocks cheaper.

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