January 2, 2015
By Steve Blumenthal
Each month, I like to look at the market’s valuation to get a sense of potential upside reward relative to downside risk. Today, let’s look at three valuation measures, one based on reported earnings through 12-31-2014, one based on operating revenue, and the last one, Warren Buffett’s favorite valuation indicator.
In short, I see a 2015 upside target of 2300 with probable downside risk at 1750: a good first half with a challenging second half. The tape remains favorable, as does the Fed (for now).
Included in this week’s On My Radar:
- S&P Median PE with 2015 Estimated Earnings Growth (Upside Target 2300, Downside Target 1750)
- S&P 500 Price/Operating Earnings Ratio
- Stock Market Capitalization as a Percentage of Gross Domestic Income – Warren Buffett’s Favorite
- Trade Signals – Weight of Evidence Supports Aged Bull Market, 12-24-2014
S&P Median PE with 2015 Estimated Earnings Growth (Upside Target 2300, Downside Target 1750)
Until recently, most analysts were expecting earnings gains of roughly 8.8% for the S&P 500 in 2015; however, thanks to the big drop in oil prices and its impact on energy stocks, earnings growth for 2015 has been lowered to 7.6%.
The overall earnings adjustments have been rapid, as energy stocks make up roughly 9% of the S&P 500 Index. Just a few weeks ago, earnings growth in the S&P energy sector was expected to be down 13.6 percent in 2015, but it is now expected to be down 21.3 percent, according to S&P Capital IQ.
Let’s look at the following S&P 500 Median PE chart and then factor in 2015 earnings growth of 7.6% to see what it might tell us about potential future return and risk. I favor median PE as it eliminates the extreme outliers and is based on actual reported earnings (not Wall Street’s forward and generally overly optimistic earnings estimates). Here is some sound advice from NDR on how to think about any PE measurement:
“P/E valuation-based indicators are often used as a sentiment indicator, with high valuations indicating high optimism and low valuations indicating pessimism. Extreme deviations from the norm, or median, are watched for to signal high or low risk periods. The Standard and Poor’s 500 Stock Index typically performs better when the Standard and Poor’s 500 Stock Index Median P/E is below its historical median, than when valuations are far above average.” Source NDR
I find it useful to compare the current level relative to what the same measurement process has historically told us about forward returns. The idea is to get a feel for reasonable upside and downside reward and risk targets. Such an analysis can help us know when it makes sense to hedge and when not to hedge.
Following is the median PE based on actual earnings data from 1964 through 2014:
The chart shows the Standard and Poor’s 500 Stock Index vs. Standard and Poor’s 500 Stock Index Median PE Ratio (as calculated by NDR). Earnings are based on 12-month trailing figures.
The orange arrow (bottom right) shows the median PE at 21.2%. The orange arrow (top) shows the S&P 500 Index to be fairly valued at 1624.92.
The bottom section uses standard deviation to show points in time when median PE was overvalued and undervalued.
Using +1 standard deviation to estimate overvaluation, by this measure, the market is overvalued at 2125.63, about 3.2% above the current level of the S&P 500 Index. You can also see that the market went to rare +2 Standard Deviation in the late 90’s. It went to near -1 in 2008.
Now, if we factor in S&P Capital IQ’s 7.6% 2015 earnings growth estimate (which is, by the way, very close to 2014’s expected growth of 7.7%), I believe that a reasonable upside target for the S&P 500 Index is 2300 and fair value to be approximately 1750.
Since trend evidence remains bullish and “Don’t fight the Fed” a primary theme, I believe that 1750 (fair value) is a reasonable downside target (though that could change in the second half of 2015 if the Fed begins to tighten and a sovereign debt crisis develops as I predict).
The next valuation chart looks at price to operating earnings. It too suggests the market is expensively priced and comes to a similar “fair value” conclusion as Median PE.
S&P 500 Price/Operating Earnings Ratio
Stock Market Capitalization as a Percentage of Gross Domestic Income – Warren Buffett’s Favorite
Warren Buffett mentioned some years ago that this was his favorite valuation metric. I’m not sure he holds the same view today but if he does I’m sure he is concerned about the “bubble territory” conclusion.
Given that we are 21.1% overvalued (according to Median PE), I looked back to a piece I wrote for Forbes last May and clipped the following:
The performance difference is dramatic. On average, one year after a low valuation, the market rose by 19.4%. One year after a high valuation, it dropped by 3.6%. When the market has been fairly valued, it increased 8.0%.
Then, as now, trend evidence remains positive, as does the support from the Fed. Given my bullish short-term view on the U.S. dollar (click here for the Forbes 2015 outlook piece), U.S. assets remain attractive relative to much of the world. I believe that global capital flows will accelerate to dollars and to U.S. equities. The drivers are higher relative interest rates, the planet’s strongest economy, and a coming sovereign debt crisis (a global rush to dollar-denominated assets – a safe haven).
Despite the relative overvalued nature of U.S. stocks, I am expecting a favorable first half and a more challenging second half. I believe that we’ll see 2300 before we’ll see 1750; however, I look to the weight of evidence that I post each week in Trade Signals to guide positioning and risk management. As Art Cashin says, “Stay wary, alert and very, very, nimble.”
Trade Signals – Happy New Year (Cyclical Trend Evidence Remains Bullish) – 12-31-2014
The weight of evidence continues to support the continuation of the current cyclical bull market trend. Risk is high as the equity market remains overvalued and the cyclical trend aged. Investor sentiment has once again reached Excessive Optimism (suggesting a pause or near-term correction).
Seasonal trends are favorable, years ending in 5 have done exceptionally well historically and 2015 marks the third year in the presidential election cycle (the most bullish in the four year cycle with the first two quarters historically providing most of the gains).
Included in this week’s Trade Signals:
- Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks Remains Bullish
- Volume Demand Continues to Better Supply – Remains Bullish for Stocks
- Weekly Investor Sentiment Indicator:
- NDR Crowd Sentiment Poll: Extreme Optimism (Short-Term Bearish for Stocks)
- Daily Trading Sentiment Composite: Extreme Optimism (ST Bearish for Stocks)
- The Zweig Bond Model: Cyclical Trend for Bonds Remains Bullish
Click here for the full link, including updated charts, to Wednesday’s Trade Signals post (trend and sentiment charts)
Conclusion and Happy New Year
Valuation measurements do a great job of identifying potential forward return (low today) and can help give us get a good feel for potential risk and reward, but they don’t really tell us much about returns over the short term.
Understanding where you are at any point in time can help you decide to position your portfolio either more aggressively or more conservatively. If risk is high, hedge what you have. If risk is low, get aggressive and buy (unhedged).
In this regard, valuation measures may not tell us much about returns over the short term, but they are good at measuring risk and probable long-term forward return. Today, overweight equities but hedge. Forward expected 10-year returns are low.
We stood at the top of the world on New Year’s Eve (picture atop Snowbird, Utah with Alta in the background) and went to bed early, tired and happy. Pictured is Susan (center), her three boys, and me and my awesome three, grateful, blessed, and lucky.
Thank you for your interest in this weekly piece. I hope you find it helpful.
Wishing you a healthy, happy, and prosperous New Year!
With kind regards,
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
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