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Stocks Are Seeing Multiple Expansions, Even as Earnings Slow

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Stock markets stay resilient

The US stock markets continue to show resilience even though equities face several headwinds. The tech-heavy NASDAQ Composite Index (QQQ) rose 0.34% on March 28, while the broader S&P 500 Index (SPY) climbed 0.36%. The gains came after US-China trade tensions eased on March 28 as negotiations resumed.

The S&P 500 is up 13.26% YTD (year-to-date), while the NASDAQ Composite Index is up 16.5% YTD. The rally this year has been mostly driven by sharp multiple expansions, meaning investors are ready to pay a premium for US stocks.

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Usually, multiples expand and stocks trade at a premium when earnings growth is expected to be robust. This expectation is why tech stocks have traded at a premium historically—especially so in the last decade or so. However, the current bout of multiple expansions comes at a time when the global economy and earnings growth are major worries.

Stocks are trading at relatively high valuations

The S&P 500 is now trading at 21.0x its trailing-12-month earnings compared to slightly below 19.0x back in December 2018. This difference means that investors are paying a premium at a time when earnings growth is projected to slow. Meanwhile, tech stocks, as usual, are trading at a premium to the broader markets.

More progress in US-China trade negotiations will likely cause the markets to spike. In fact, this possibility has been the main reason why the markets have held up quite well this month despite increasing signs of a global slowdown. As the graph above shows, Treasury yields have nose-dived due to softening economic data.

The earnings season is just around the corner. If earnings growth slows, as is expected, stocks are likely to stall. The volatility index (VXX) is hovering at ~14.4, far below its long-term average of ~20, suggesting that the markets are complacent.

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