January 17, 2014
By Steve Blumenthal
Things are not always as they seem. In this business, it really is a game of opposites. Today the market is expensive by most measures. This is a confusing topic for many and there is always someone who says the market is cheap. Who to believe? What process is best to follow?
Today, let’s take a look at current market valuations and see what they might say about forward expected returns.
In this week’s On My Radar, I share the following:
- The Market is 20% Overpriced Relative to the 50 Year Median PE of 16.7
- Goldman’s Chief Strategist David Kostin – Current Valuations are Lofty
- High Valuations Lead to Low Returns – We are in Quintile 5
- The Great Buyback Surge Is Over – Earnings have likely peaked for now
- The S&P 500’s Price to Sales Ratio – Here too… Expensive
- Real Final Sales Signaling Recession – The Most Important Chart of the Year
- Trade Signals – Investor Sentiment Remains Extremely Optimistic
The Market is 20% Overpriced Relative to the 50 Year Median PE of 16.7
Let’s start with my favorite market valuation chart – NDR’s Median Price to Earnings. I like it because it is based on reported earnings and not Wall Street analysts’ over-optimistic forward earnings guestimates. Wall Street analysts tend to point to the earnings they see ahead; the problem is that they tend to be over-optimistic only to be revised lower at a later date. I prefer to look at reported earnings to get a sense of where the market stands compared to its historical fair value.
In the next chart you can see that the market is 20% above its 49.8 Year Median P/E putting Fair Value at 1478.63.
Goldman’s Chief Strategist David Kostin – Current Valuations are Lofty
This from Goldman’s David Kostin: The current valuation of the S&P 500 is lofty by almost any measure, both for the aggregate market as well as the median stock: (1) The P/E ratio; (2) the current P/E expansion cycle; (3) EV/Sales; (4) EV/EBITDA; (5) Free Cash Flow yield; (6) Price/Book as well as the ROE and P/B relationship; and compared with the levels of (6) inflation; (7) nominal 10-year Treasury yields; and (8) real interest rates. Furthermore, the cyclically-adjusted P/E ratio suggests the S&P 500 is currently 30% overvalued in terms of (9) Operating EPS and (10) about 45% overvalued using as reported earnings.
High Valuations Lead to Low Returns
We are currently in the Quintile 5 (Highest P/E), projecting a forward annual return of 4.07%.
What if the earnings part of the equation was driven by something other than revenue growth? The question to be asked today is whether future earnings can be sustained.
The Great Buyback Surge Is Over
By now most investors are aware that the primary reason there was EPS growth last year (or the prior two years) was the relentless buying back of their own stock by corporate treasurers, accounting for 75% of the increase in S&P 500 earnings per share even as revenues stagnated for the second year in a row and actual earnings growth was comatose at best.
At $500 billion in net stock buybacks in 2013, this was an immense amount of bidding power, equal to half of the Fed’s entire annual liquidity injection.
- My comments here: The point here is that if IBM’s overall earnings were flat in 2013 but they used some of their excess cash or took on new debt to buy back shares, their actual earnings per share (EPS) look better since the current earnings would be compared against fewer shares outstanding. So looking at the S&P 500 companies as a whole, 75% of the increase in earnings was the result of stock buy backs and not increased revenue. What happens if revenues remain flat and share buybacks go away? Or worse, corporations issue new stock that will cause earnings per share to go down if revenues remain flat. Same earnings against more shares equals lower EPS. When you compare lower EPS against current price, the P/E goes up. Expect this moving forward.
While EPS was artificially boosted by an allocation of capital that most would say is the least efficient in terms of future growth, the only good thing that could maybe be said about the second highest annual corporate buyback in history was that companies still saw their stocks as cheap. After all, not even the most aggressive of CFOs would green light a massive buyback campaign if they expected their stock to plunge.
That is no longer the case.
As JPM’s Nikolas Panigirtzoglou notes in his latest “Flows and Liquidity” weekly, “the S&P 500 Index Divisor rose in Q4 following a flattish pattern in the previous two quarters.” This means that after buying back stock for two years in a row, companies have once again turned to net sellers and as a result are increasing the divisor (aka the denominator in the EPS fraction) of the S&P 500, which means two things: i) the boost to EPS from buybacks is now over and ii) even corporations view the market as overvalued and prefer to sell their stock rather than buy it.
The S&P 500’s Price/Sales Ratio – Here too… Expensive
Real Final Sales Signaling Recession – The Most Important Chart of the Year
During the period, real final sales growth slipped to just 1.9% from 2.1% in Q2. This is not a good sign according to Bloomberg Briefs Economist, Rich Yamarone.
- “When the year-over-year change in the level of real final sales falls below 2.0%, the economy eventually slips into recession,” he said to Business Insider.
This is such a concern that Yamarone told Business Insider that this was the most important chart of the year.
Source: http://www.businessinsider.com/real-final-sales-gdp-warning-recession-2013-12
I conclude that the market is overpriced, overbought and over-bullish. I remain firmly in the hedge your stock exposure camp, expecting a meaningful correction. Recession? I’m guessing 2015, but one just can’t discount the chart above.
Trade Signals – Investor Sentiment Remains Extremely Optimistic
Click here for a link to Wednesday’s Trade Signals.
The calendar is taking shape. Up next is the Index Universe ETF Conference on January 26-29, 2014 at the Westin Diplomat in Hollywood, Florida. Please let me know if you are attending. I’ll be in Bend, Oregon from February 6-10 to huddle with my management team along with my good friend and business coach, Jim Ruff. Jim is the retired president of Oppenheimer Fund Company. When I need advice, I look to Jim. We will sneak in some time to ski, but it is Jim’s guidance that I look forward to the most. His experience and insights simply can’t be quantified. Oh, and the town is full of micro breweries. An après ski IPA is sounding like a good idea.
I’ll be in NYC on February 19 and 20 for several media interviews, in San Diego from February 26-28 at a mutual fund conference and speaking at the NWA Financial Forum in Rogers, Arkansas along with Governor Mike Huckabee on March 6. I’ve never been to Arkansas and I am really looking forward to meeting Governor Huckabee. Hopefully I can arrange the flight to connect through Dallas. I’d like to check out John Mauldin’s new condo and catch a dinner with my good friend.
As a quick aside, if you ever have any questions around sales and distribution, please feel free to reach out to Michael Sciortino at CMG. Mike was one of Jim Ruff’s top wholesalers at Oppenheimer and is a wealth of knowledge. Feel free to seek him out if you need some ideas around growing your sales and distribution – he is a master salesman. Mike can be reached at Michael@cmgwealth.com.
Wishing you a relaxing weekend!
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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