Archive for June, 2017

QVM Market Notes: Bull and Bear Markets and U.S. Large-Cap Stocks Valuations

Friday, June 16th, 2017

QVM Clients (May 6, 2017):

The current Bull market is the second longest with the second largest cumulative gain since 1900. In another 16 months, if it continues as according to the “Street” consensus, it will be the longest running Bull since 1900.

(click images to enlarge)

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Augmented valuations based on expectations of Trump getting his key economic agenda implemented soon (including tax reform, overseas capital repatriation, and massive infrastructure investments) is substantially diminished at this time due to all the conflict and dysfunction at the Federal level. Accordingly, most or all of any “Trump Bump” in U.S. stock valuations may be unwarranted.

There are also many risks facing stocks. I have my list. You have your list. They are both good. Both lists are significant, ranging from Central Bank actions, to globally shifting national political profiles, to spreading terrorism, to highly indebted governments, to disappointing strength of GDP growth, etc.

Valuation is an issue, but not likely to be a cause of the next Bear market. Markets can remain overvalued or undervalued for extended periods. A market peak is created not by overvaluation, but by an event or circumstance that causes investors to lose confidence or become fearful.

Of valuation and inevitable Federal Reserve actions, famed investor Bill Gross, formerly CIO at PIMCO, said last week “Instead of buying low and selling high, investors are buying high and crossing their fingers”.

Independent of the Trump goals, there is growth in the U.S. and the world, which is keeping stocks moving forward, but in the U.S. stocks may be a bit ahead of themselves.

In the face of most U.S. stock valuation multiples being well above median levels, one key measure is much better than median and helps keep money flowing into stocks — that is the spread between the yield on Treasuries and the earnings yield (earnings divided by price) of stocks. One other key measure is in the attractive zone:

  • Earnings yield spread to 10-Yr Treasuries yield is well above the 50-year median, and the internet era median, and only a bit below the 145 year median — ATTRACTIVE
  • Dividend yield is approximately at the median level during the internet era — ATTRACTIVE
  • BUT, other price multiple measures are in the expensive range.

Earnings Yield Spread

Due to depressed interest rates, stocks continue to generate an earnings yield greater than Treasuries — and in a world where investors chose between alternatives, they are choosing stocks while the yield spread is positive in favor of stocks.

Very few living and currently active investors have more than 50 year of investment experience, which means for almost every investor, the current earnings yield spread makes stocks more attractive than bonds from a return perspective (although not from a maximum drawdown risk perspective).

Before the 1960’s (and before the academic field called “Modern Portfolio Theory”) investors required a lot more yield advantage from stocks than bonds. Will those days every return? Probably not, but it is not impossible.

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S&P 500 Large-Cap Valuation Multiples in the Internet Era

  • Price to Earnings
  • Price to Cash Flow
  • Price to Sales
  • Price to Book Value
  • Dividend Yield

All multiples are above median, except for dividend yield which is at the median level. Only price to sales is very high in historical terms. Conclusions, S&P 500 is expensive by these measures (except for dividend yield), but is not excessively expensive.

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Here are 10-year charts of the trailing and forward P/E ratio of the S&P 500 from FactSet.  Both are well above their 5-year and 10-year averages.

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Growth at a Reasonable Price

Five-year forecasts are aggressive, because they see historically high earnings growth rates, and earnings continuing to outpace sales signficantly – that can’t go on perpetually. The S&P 500 is priced in the upper part of the mid-range of history with the 1 year forward P/E ratio about 1.5 times the 5 year earnings growth forecast (the “PEG Ratio”).

Here is the forecast from the most recent Standard and Poor’s spreadsheet for the S&P 500 (Standard and Poor’s opinion only).

 

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Yardeni Research publishes a S&P 500 PEG ratio time series from 1995 forward.

It shows that the high (most expensive based on forecasts) was between 1.65x to 1.70x reached in 2015 and 2016. The low (least expensive based on forecasts) was in 2008 during the last crash. The median is in the vicinity of 1.30x to 1.35x. The current ratio is about 1.4, — just a bit more expensive than the median market in the internet era.

Mean reversion of valuation multiples is a powerful force, and mean reversion of all of the above measures (except for dividend yield), when pressured by outside forces, would cause U.S. stock prices to either decline, or slow down for economics to catch up. The problem is predicting when mean reversion will kick in.

We will keep an eye out for change.

Directly Related S&P 500 Funds: SPY, IVV, VOO, VFINX