“I can’t change the direction of the wind, but I can adjust my sails to always reach my destination.”
- Jimmy Dean
Over the course of the first quarter, Standard and Poor’s lowered their forecast for 2015 earnings from $135 per share to $112 per share to $110 per share. With prices already high relative to corporate earnings, such a trend is not an investor’s friend.
Let’s take a look today at current valuations and see what they may tell us about the market’s return over the next ten years. Hint: it’s very low. Be prepared to adjust your sails.
Included in this week’s On My Radar:
- Quarter End Valuations
- The S&P 500 Index and Federal Reserve Intervention
- Trade Signals – Trend Remains Bullish, Risk Remains Elevated
Quarter End Valuations
- Median P/E First, P/E is short for the ratio of a company’s share price to its per share earnings. As the name implies, to calculate the P/E, you simply take the current stock price of a company or index like the S&P 500 and divide by its earnings per share (EPS). Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. Median P/E removes the few companies that are outliers in the index (those on the high earnings side and those on the low earnings side) and gives us a sense of how the majority of the 500 companies in the index are doing.
When we compare the Median P/E against the historic average of Median P/Es, we can get some footing on what returns probably could be. Simply, is the market inexpensively priced or richly priced? The next chart, courtesy of NDR, shows the market to be richly priced. Median P/E is my favorite valuation indicator.
Note that fair value on the S&P 500 at 1600.42 as indicated by the orange arrow. The S&P is overvalued at 2093.14 (the S&P 500 index is at 2100 today). Undervalued is at 1107.71. I think those levels pretty much shape out fair value and risk and reward. Though the market may move higher, ultimately valuations will win. Remember, we want to be buyers when upside return is greatest.
- Median Price to Sales Ratio
- Price to Operating Earnings Ratio
In this next valuation chart, note the return history three months to two years later when the price to operating earnings ratio is greater than 18.2 (orange highlight). It’s best to be an aggressive buyer of equities when the price to operating earnings ratio is less than 8. It currently stands at 18.39 as of March 31, 2015. Here too the market is expensively priced.
By the above measure, the market is fairly valued at 1613.51, overvalued at 2046.41 and undervalued at 899.52 (that is a scary S&P 500 level).
- Crestmont and Shiller P/E
Periods of overvaluation and undervaluation can go on for some time. Therefore, they are not useful in determining market direction. However, they can play a role in helping us understand probable future returns and thus can help us shape the equity exposure we/you place within client portfolios. It can also help to identify high risk and low periods – simply when it makes more and less sense to implement equity risk hedges.
Finally, as it relates to valuation and forward return, I next share one of my favorite forward expected return charts. It too says to expect below normal forward equity returns – really low at approximately 2.25% (annualized before inflation).
Household Equity Percentage vs. Rolling 10-Year S&P 500 Index Total Return
The large red arrow shows a forward 10-year expected return of -3% (1999 – 2009). The small red arrow shows a forward 10-year expected return of +1% (2007 – 2017). The green arrow shows a forward expected return of 13.25% (2009 to 2019) and the yellow circle shows where we are today (expecting a forward 10-year expected return of approximately 2.25%).
The bottom green line shows the forward return potential of over 19% per year at the beginning of the great bull market in the early 1980s. I was a very young institutional broker at Merrill Lynch back then. Believe me when I say, nobody wanted to own stocks. A long secular bear market had ended but nobody knew it at the time.
If equities were cheaply priced, I’d be less concerned. They are not. By all reasonable measures, equities are expensively priced yet that doesn’t mean U.S. stocks won’t move higher (I’m in the “don’t fight the trend” camp). Overall, risk is high so put a disciplined game plan in place to deal with the high risk, low forward returns and the coming change in trend. I share a few risk management ideas each week in Trade Signals.
“I can’t change the direction of the wind, but I can adjust my sails to always reach my destination.” As shared in the intro quote – let’s keep the same in mind and do our best as it relates to our portfolios.
With kind regards,
Steve
Stephen B. Blumenthal Founder & CEO CMG Capital Management Group, Inc.
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