Valuations High But Not Crazy

6/15/2015


While Federal Reserve Chairwoman Janet Yellen caused only a minor market slide when she said stock prices were "quite high" on May 6, her statements triggered a torrent of Wall Street commentary. Both bulls and bears put their own spin on the U.S. stock market's valuation, but much of the analysis supported two conclusions:

Relative to historical norms, stock prices are high but not ridiculously so. The S&P 500 Index trades at more than 21 times trailing 12-month earnings, 19% above the 50-year norm of 18 and 5% above the 20-year norm of 20. The median trailing P/E for stocks in the S&P 500 is 20, 10% above the 20-year norm. On both an absolute basis and relative to historical norms, the median P/E is even higher for stocks in the S&P MidCap 400 and S&P SmallCap 600 indexes.

Many of the most bearish commentators argue that stocks should be valued based on average earnings over the past decade, since trailing 12-month earnings tend to be near their peak when investors are most enthusiastic about stocks. On the so-called Shiller P/E, which is based on the S&P 500 Index's average inflation-adjusted earnings over the trailing 10 years, the current level of 27 is well above the 50-year norm of 20.

The Shiller P/E has some flaws; it has pegged stocks as overvalued since 2009, right before a nearly six-year, 92% surge in the S&P 500. The Shiller P/E's estimate of fair value will jump in 2020, when 10-year average earnings no longer include the huge charges taken by banks and others in the financial crisis.

The Shiller P/E also suffers from the same problem as all valuation yardsticks: The historical norm changes over time. While today's Shiller P/E is a scary 36% above the 50-year norm of 20, it is only 5% above the 25-year norm of 25.

Relative to bond yields, stocks remain unusually attractive. Expressed in academic terms, the equity risk premium is higher than normal today. The equity risk premium represents the extra return one can expect from stocks compared to bonds. While analysts measure this premium in a variety of ways, most agree it is above historical norms because bond yields are so low.

Based on the spread between bond yields and earnings yields (earnings/price ratios) on stocks, stocks are unusually attractive relative to 25- and 50-year norms. All else equal, a return to 25-year norms would require a jump in 10-year Treasury yields to about 4.2%, up from the current 2.4%. Baa corporate bond yields would need to jump to about 6.9%, up from 5.1%.

Growth at a discount

Questioning whether the stock market is cheap or expensive is a worthwhile pursuit. Bear markets are far more likely when the market is expensive.

But you should also ask yourself another question: Are there enough reasonably valued stocks available for you to build a diversified portfolio? If your strategy is contingent on buying truly cheap stocks, today's environment is very difficult. Only 9% of S&P 500 stocks have trailing P/E ratios below 12, well below the 20-year norm of 16%.

We like truly cheap stocks. But our strategy does not depend on them. We focus on finding high-quality growers at reasonable valuations, and the 31% of stocks with P/Es of 12 to 18 is nearly equal to the 20-year norm of 32%.

As shown in the table below, we are not content to settle for stocks with reasonable valuations. For the 25 stocks on our Buy List, the average trailing P/E is 17.1, nearly 18% below the average of 20.8 for S&P 500 stocks. Yet the average trailing 12-month and five-year sales growth for our Buy List is at least twice that of the S&P 500. The same is true based on the growth rates for cash flow and per-share earnings.

GROWTH AT A DISCOUNT: OUR BUY LISTS BY THE NUMBERS
Relative to the average for stocks in the S&P 500 and S&P 1500 indexes, stocks on our buy lists have higher Quadrix scores, cheaper valuations, superior trailing and expected growth rates, and better earnings-estimate trends. For example, the average company on our Focus List is expected to deliver 16.0% current-year growth in per-share earnings, versus 3.9% for the average S&P 500 company.
Focus
List
Buy
List
Long-
Term
Buy List
S&P 500
Index
S&P 1500
Index
Average Quadrix Scores
Overall
90
89
85
60
59
Value
70
67
70
57
56
12-Factor Sector
85
81
75
47
50
Reranked Overall Sector
86
86
82
50
50
Average valuation ratios
Price/earnings, trailing
16.6
17.1
16.2
20.8
22.0
Price/earnings, est. current year
15.5
15.8
15.4
20.5
21.6
Price/earnings, estimated next year
13.9
14.0
13.8
18.7
19.2
P/E to growth (PEG) ratio
1.3
1.3
1.3
1.3
1.3
Average historical growth rates
Per-share earnings, 12 months (%)
31.1
30.2
27.7
10.9
11.4
Revenue, 12 months (%)
12.3
13.2
11.3
5.6
7.6
Cash flow, 12 months (%)
19.4
21.2
20.9
7.0
9.1
Per-share earnings, annual. 5 yr. (%)
35.5
30.6
27.6
14.9
15.2
Revenue, annualized five year (%)
16.5
15.2
12.8
7.6
8.7
Cash flow, annualized five year (%)
30.4
27.3
23.5
8.3
9.2
Average estimated per-share profit growth
Current year (%)
16.0
17.5
13.3
3.9
6.5
Next year (%)
12.0
12.0
11.5
13.2
16.9
Annualized five-year (%)
12.6
13.1
12.7
10.3
11.2
Average 3-month change in per-share profit estimates
Current year (%)
1.1
1.6
0.0
(1.5)
(1.4)
Next year (%)
0.8
1.3
0.1
(2.5)
(1.8)

Stocks on our Buy List are expected to deliver average growth in per-share profits of 17.5% in their current fiscal year, versus 3.9% for S&P 500 companies. For next year, the average forecasted growth of 12% for the Buy List is slightly below the average of 13.2% for S&P 500 companies, but the Buy List has a considerably higher expected five-year growth rate.

Conclusion

We'd like to see better share-price action from the Dow Transports and other cyclical groups, as continued underperformance would undermine the case for a rebound in corporate earnings growth. And we'd like to see the Dow Industrials avoid a close below 17,164.95, as such a breakdown would represent a bear-market signal under the Dow Theory.

Still, we don't think valuation alone is reason enough to exit the stock market. For now, we're holding about 85% of our buy lists in stocks, with the remainder in a short-term bond fund.


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