Stocks Are Not All That Cheap

|
 |  Includes: DIA, IYM, IYZ, SPY, VDC, XLE, XLF, XLI, XLK, XLU, XLV, XLY
by: The Financial Lexicon

I have lost track of the number of times I have seen on business television or read in the financial press a stock market pundit claim that equities are cheap because the S&P 500 (NYSEARCA:SPY) is trading below its historical average valuation. But why should investors use historical valuations as a guide when today's equity market drivers, as a collective group, are unlike anything the U.S. markets have ever experienced?

Let me remind investors about four drivers of earnings growth and stock prices over the past few years. Collectively, these four things have played a far larger role than I believe most investors appreciate in driving stocks higher since the 2009 lows. In no particular order, they are:

1. Massive cost cutting - Helps earnings per share.

2. Stock buybacks - Helps earnings per share.

3. Low bond yields - Helps lower the cost of capital for companies and provides professional investors with a stock market selling point for their clients. That selling point sounds something like this: "The S&P 500 is yielding more than bonds. Therefore, you should buy stocks. Additionally, bond yields have nowhere to go but up, which means that you will lose money in bonds."

4. Quantitative easing (QE) - The massive liquidity the Fed has injected into financial markets has played a significant role in propping up asset prices across the board.

I am not saying that revenue growth was completely absent from the huge rise in operating earnings since the 2009 bottom. But when other factors play such a large role in getting earnings per share and stock prices to where they are today, it should not surprise anyone that the S&P 500's multiple is "only" 14.35 (1426.19 divided by $99.38 in operating earnings per share). The quality of earnings matters. Why does the S&P 500 deserve a 16 or 17 multiple given the current quality of its earnings? When combining the four aforementioned drivers of earnings and stock prices in recent years with no end in sight to slow economic growth, persistent policy uncertainty from Washington, D.C., and still no resolution to Europe's crisis, I think 14 to 15 times earnings is a generous multiple for the stock market.

Some readers may be thinking "But the market is forward looking, so I would rather focus on future earnings expectations." I would respond with the following:

1. Is today's "forward-looking market" the same one that was making new all-time highs on the S&P 500 and Dow Jones Industrial Average (NYSEARCA:DIA) in October 2007 after the financial crisis had already begun and just weeks before a recession would officially start in the U.S.?

2. In my May 1, 2012 article, "S&P 500 Earnings Summary and Forward Projections," I noted that year-end 2012 and 2013 S&P 500 operating earnings estimates were $105.64 and $119.35 respectively. Today, those numbers stand at $99.38 and $112.82 respectively. Analysts are currently projecting operating earnings to increase 13.52% in 2013. In 2012, operating earnings increased just a bit more than 3%. Do you think 2013 will be that much better than 2012? By the way, with a 14.35 P/E and a roughly 3% operating earnings growth rate for 2012, the S&P 500 is now trading with a trailing price/earnings-to-growth (PEG) ratio of 4.78. A PEG ratio of more than 4 certainly doesn't sound cheap. Of course, based on forward-looking estimates, the PEG ratio is lower. But you have to believe those forward projections for that to be the case. Recent history is not kind to analysts' abilities to predict S&P 500 earnings 12 months in the future.

Just because the stock market of today might not be that great at predicting rapidly approaching economic woes (I would contend the market of today is and will be terrible at doing that), and just because the S&P 500 is not necessarily cheap at today's valuation, doesn't mean that long-only investors should sit on their hands and do nothing.

In recent years, ETFs have become a very popular way for investors to put their money to work in various parts of the financial markets. Within the world of equities, sector ETFs allow investors to narrow in on those segments of the broader-market that might be cheaper than others or cheaper than the market as a whole. With that in mind, I hope you find the following table useful. It shows the 10 different sectors of the S&P 500, a corresponding ETF (ticker in parentheses) that you could use as a means of gaining exposure to those sectors, the sectors' P/Es for 2012 and 2013, and the sectors' expected growth rates for 2013. The P/Es come from S&P's 12/20/2012 "S&P 500 Earnings and Estimate Report." The sector growth rates were calculated using data from the same report.

S&P 500 Sectors

2012 P/E

2013 P/E

2013 Expected Growth Rate

Consumer Discretionary (NYSEARCA:XLY)

17.17

15.02

14.34%

Consumer Staples (NYSEARCA:VDC)

16.68

15.25

9.43%

Energy (NYSEARCA:XLE)

12.05

11.19

7.73%

Financials (NYSEARCA:XLF)

13.46

11.49

17.07%

Health Care (NYSEARCA:XLV)

14.48

12.85

12.76%

Industrials (NYSEARCA:XLI)

14.40

13.16

9.49%

Information Technology (NYSEARCA:XLK)

13.94

11.84

17.76%

Materials (NYSEARCA:IYM)

16.01

13.05

22.70%

Telecommunication Services (NYSEARCA:IYZ)

19.25

16.63

15.78%

Utilities (NYSEARCA:XLU)

15.41

14.50

6.23%

Click to enlarge

I know it is tempting to use historical valuations as a means for determining whether today's market is cheap or not. But by doing so, investors fail to take into account all the various inputs that make today's investing environment unique from a historical perspective. Over time, the quality and perceived sustainability of earnings growth will matter to investors. Today's quality and perceived sustainability does not justify the higher historical multiples that many investors long for. That may change in the future. But, for now, I hope that you find this article useful in thinking through whether the market is actually cheap today. On a final note, remember that just because something is not cheap does not mean you must sell it or even that you can't buy it. It may simply mean that expectations of future returns need to be adjusted accordingly.

Good luck and happy investing in 2013!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.