Got To Get Better In A Little While

10/28/2013


I've kept nearly all our buy lists in stocks since last year, partly because I felt stocks were attractively priced despite below-average growth in corporate profits.

Now I'm not so sure.

Without better profit growth, the broad market may be hard-pressed to make much headway, as the typical U.S. stock is richly valued versus long-term norms. Consider these statistics for the S&P 1500, an index of large, midsized and small stocks created in 1994:

• The median trailing price/earnings ratio of 20.3 is well above the norm of 18.2 since October 1994 — and higher than 89% of month-ends since October 1994. Based on enterprise value/EBITDA, price/cash flow, and price/sales ratios, today's median is higher than at least 98% of month-ends.

• Relative to trailing three- and five-year norms, the median S&P 1500 stock has never been so expensive. That partly reflects the fact that stocks were unusually cheap after the 2008-2009 bear market. Still, today's comparisons to five-year norms are more extreme than those seen in at least 99% of month-ends based on price/earnings, price/book, and price/sales.

• At 5.2%, the average yield on Baa-rated corporate bonds is about 0.15% higher than the trailing earnings yield (earnings/price ratio) of the median S&P 1500 stock. Baa yields have exceeded the median earnings yield by an average of 1.25% since October 1994, so the median stock is still cheap in comparison to bond yields. But the earnings yield was about 1.5% higher than the Baa yield a year ago, so the relative appeal of the median stock has diminished considerably.

• The median S&P 1500 company has delivered above-average growth in sales, earnings, and dividends over the last three and five years, but growth over the last 12 months has been well below historical norms.

Quadrix: today vs. yesterday

While our Quadrix rating system shows which of today's stocks are most attractive, it could not show how today's stocks compare to those of yesterday — until now. We recently looked at the middle-ranked S&P 1500 stock for all Quadrix variables, then compared today's middle-ranked stock to those of past months.

For example, the middle-ranked stock (at the 50th percentile) in the S&P 1500 has a trailing P/E of 20.3. That is lower than only 11% of month-ends since October 1994, so today's 50th-percentile stock earns a score of 11 (out of 100) for trailing P/E. We repeated this scoring process for each of the more than 80 variables used in Quadrix, then generated category and Overall scores based on the same weighting system used in Quadrix now.

We also compared today's stocks to those of the last 19 years at the 25th, 75th, and 90th percentiles. Comparing valuations and growth rates from one era to those of another is problematic, and we made assumptions regarding missing data. But no matter how we crunch the numbers, the results are not pretty.

As shown at below, today's 25th-percentile S&P 1500 stock earns an Overall score of 27, meaning it compares favorably to about 27% of 25th-percentile S&P 1500 stocks of the past 19 years. Scores at the 50th, 75th, and 90th percentiles were even worse. For all four groups, today's stock earns a Value score of 11 or lower.

SIMULATED QUADRIX SCORES: TODAY VERSUS YESTERDAY
To generate the simulated Quadrix scores below, we looked at how S&P 1500 stocks compare to historical periods based on the more than 80 individual variables used in Quadrix. For example, today's 90th-percentile stock on P/E ratio has a P/E lower than about 13% of the month-ends for 90th-percentile stocks since October 1994, so today's stock gets a score of 13 on that variable. Next, we calculated category and Overall scores based on Quadrix's current weighting system. As shown, today's 90th-percentile stock compares very poorly based on Quadrix Value scores, resulting in a poor Overall score. The same holds true for stocks at the 75th, 50th, and 25th percentiles.
Momen-
tum
Value
Quality
Financial
Strength
Earnings
Estimates
Perfor-
mance
Overall
90th percentile
89
7
46
56
40
61
12
75th percentile
53
9
20
58
44
75
12
50th percentile
16
9
30
58
85
79
15
25th percentile
41
11
40
69
78
83
27


Conclusion

With valuations expensive, stocks may stagnate or worsen unless profit growth accelerates. Given today's relatively tame inflation, investors are unlikely to be hugely disappointed if median per-share-profit growth continues at the roughly 8% pace of the past year — especially if bond yields remain low. The bigger risk is that earnings growth will downshift again as profit margins retreat from record highs — or that inflation and bond yields will jump and stocks won't look so good in comparison.

On the flip side, I'm encouraged by the stock market's recent price action, which suggests that economic and corporate profit growth may get better in a little while. Continued strength this earnings-reporting season would be encouraging, especially with confirmation from the Dow Industrials with a close above 15,676.94.

ANATOMY OF A MIDDLING S&P 1500 STOCKS: TODAY VERSUS LONG-TERM NORMS
Returns have been impressive, but recent growth rates have been weak . . .
--- Total Return ---
12-Mo.
EPS
Chg.
12-Mo.
Sales
Chg.
Return
On Equity
Return On
Investment
--------- 3-Year Annualized Growth ---------
12
Month
6
Month
Cash
Flow
Div.
EPS
Sales
Recent S&P 1500 median (%)
27.8
17.2
8.2
5.2
11.1
7.4
22.1
9.0
39.5
25.0
Norm since October 1994 (%)
9.4
4.9
10.9
7.8
12.3
8.2
18.1
4.4
23.0
15.7
% of mos. lower than recent
89
89
21
19
23
22
75
91
76
74
 
. . . and most valuation ratios are near 19-year highs
Div.
Yield
(%)
Enterprise
Value/
EBITDA
P/E
Ratio
P/E To
5-Year
Median
Price/
Book
P/B To
5-Year
Median
Price/
Cash
Flow
P/CF To
5-Year
Median
Price/
Sales
P/S To
5-Year
Median
Recent S&P 1500 median
1.2
10.7
20.3
1.2
2.4
1.2
13.8
1.2
1.7
1.2
Norm since October 1994
0.9
9.0
18.2
1.0
2.2
1.0
11.3
1.0
1.3
1.0
% of mos. lower than recent
79
100
89
99
79
100
98
100
100
99

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