How to Play an S&P Pullback Below 950

RIAanalyst.com - Valuation (top-down): fair-to-overvalued - Our framework for market outlook is first and foremost concerned with valuation. We say the market is “fairly valued” if our analysis suggests an expected return for a buy-and-hold investor of between 8-12% per annum. If the expected return is less than 8%, than we would say the market is overvalued (expensive). If it is more than 12%, than we would say that equity markets are undervalued (cheap).

In our top-down analysis, we estimate a return expectation by applying a fair PE (12-17x) to forward EPS expectations and discounting back to today’s index price. The target range of 12-17 x EPS is derived from underlying assumptions about conversion of EPS to Free Cash Flow and long-term EPS growth. At present our expectation is for about a 8.7% total return on the S&P (see analysis below). While this is within our range of acceptability, its certainly bordering on overvalued.

For example, you could position yourself higher up the capital structure and get an 8.7% yield with a portfolio comprised of 60% high quality corporate bonds ((LQD), yield 6%) and 40% high-yield bonds ((JNK), yield 13%). Our “buy below” price on the S&P 500 (SPY), for an expected return of 12% or more, is 946.

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Disclaimer: This information is presented for general purposes only and should not be construed as being the primary basis for an investment decision, or as reflecting recommendations taking into account your individualized requirements. As always, consult your financial advisor before making any decision based on this or any other information. (full disclaimer)

Disclosure: Author has no position in SPY

Comments

[Trey Jarmond:]

No reason to chase this market at this level

Aug 02 08:26 AM

[Pauly B:]

The earning power and future earning power of the majors makes me believe we are overvalued here based on projected earnings. Moreover consumer confidence is not there. There is only so much companies can cut.

Aug 02 10:20 AM

[Old Trader:]

I know that the editors of SA often re-title articles, which is what happened here, is my guess. Are you suggesting a pullback to below 950 would call for trimming the fixed income allocation and adding to equities?
Imo, it would take more than a roughly 40 point drop in the S&P to start looking seriously; something more like 900-925. Having said that, there're no doubt some undervalued securities even at current prices, although it might take some digging to find them.

Aug 02 01:20 PM

[RiskReturnO...:]

I'm afraid the EPS estimates are too high, as it's assuming revenue growth starting next quarter .... PE range is reasonable, but EPS growth in the next few quarters may be too optimistic consider that unemployment rate is expected to peak in 2010 and consumer savings rate continues to increase.

A more realistic $60 EPS for 2010 and 15 PE would put the fair price at 900 for SPY.

Aug 02 01:24 PM