Still Bullish

3/3/2014


The averages have moved within striking distance of new highs, and we'd view a near-term failure to get the job done with all-time closing highs above 16,576.66 in the Dow Industrials and 7,569.89 in the Dow Transports as discouraging. We'd view a breakout above those levels as a reason to stay nearly fully invested, partly because we still think quality stocks are available at reasonable valuations.

As usual, bears have no shortage of reasons to be bearish. But many of their favorite valuation arguments boil down to three themes:

1. Stock prices are unusually high relative to earnings.

2. Earnings growth is unusually low. Or earnings are only growing because of share buybacks and cost cuts, not because of sales gains.

3. Earnings are unusually high relative to sales, and stocks will suffer when profit margins revert to historical norms.

Regarding argument No. 1, we see price/earnings ratios as middling, not high. In fact, the S&P 500 Index's trailing P/E of 18 is right in line with 30- and 50-year norms — and lower than more than half of the month-ends over the past 30 years. The index's forward P/E of 15.5 is below the 15-year average of 16.

Valuations for the S&P 500 are skewed lower by the capitalization-weighted index's large stocks, which today are unusually cheap relative to other stocks. But the median S&P 500 stock's trailing P/E near 19 is only 5% higher than the norm since 1994. For the small, midsize, and large stocks in the broader S&P 1500 Index, the median P/E of 20 is 12% above the norm since 1994.

Regarding argument No. 2, we mostly disagree. As shown below, median per-share earnings growth is running modestly below long-term norms. But median sales growth is roughly in line with long-term norms, and real growth rates look better considering that U.S. inflation is running more than 1% below the norm since 1994.

AVERAGE AND MEDIAN YEAR-TO-YEAR GROWTH RATES
Sales Change In Latest Quarter
EPS Change In Latest Quarter
--- S&P 500 ---
--- S&P 1500 ---
--- S&P 500 ---
--- S&P 1500 ---
Avg.
(%)
Median
(%)
Avg.
(%)
Median
(%)
Avg.
(%)
Median
(%)
Avg.
(%)
Median
(%)
Recent 
7.0
6.2
6.3
5.7
7.5
7.7
5.9
7.1
Norm since Oct. 1994
6.3
6.1
6.5
6.1
7.4
9.7
6.5
9.1
Recent as % of norm
110
101
96
94
101
80
90
78
% of month-ends lower
since Oct. 1994
47
47
44
39
44
22
32
24
Notes: All averages and medians exclude declines or gains of more than 75%.

For the S&P 500 Index, reported sales growth has been depressed by lower commodity prices, which have crimped revenue in the energy, materials, and utility sectors.

S&P 500 SALES GROWTH
S&P 500 Sector
2012
(%)
2013
Est.
(%)
Consmer Staples
5.5
1.2
Consumer Discretionary
6.9
12.3
Energy
2.8
(1.9)
Financials
2.5
(1.4)
Health Care
3.9
5.0
Industrials
5.0
2.7
Materials
(1.0)
3.2
Technology
7.2
1.1
Telecom Services
6.3
1.7
Utilities
(8.3)
3.3
S&P 500 Index
3.8
2.4
S&P 500 excluding
energy, materials, and utilities
5.3
4.0
Source: Standard & Poor's.

Regarding argument No. 3, the bears have a point. Because profit margins are at all-time highs, investors have been willing to pay more for each dollar of sales. If investors conclude margins are headed lower and therefore premium price/sales ratios are no longer merited, the median S&P 1500 stock would need to drop 28% to return its price/sales ratio to the norm since 1994.

Of course, nothing says profit margins must revert to historical norms anytime soon. Many of the factors that have lifted margins — globalization, technology-led productivity gains, lower corporate taxes, and the record-low share of national income going to labor — seem unlikely to be reversed in the near term.

Our advice

Subscribers should watch the averages while holding nearly fully invested portfolios, and don't settle for average stocks. Our buy lists have 91% to 98% in stocks.


Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com