It's Tougher To Find Bargains

Includes: IYY, SPY
by: AAII

"The market is no longer cheap." This is how we started our August AAII Dividend Investing newsletter. The S&P 500's approximate 18% rise in price this year so far has boosted portfolio values, but made life difficult for value investors.

To back our conclusion, I conducted an analysis on the stocks held by the Dow Jones U.S. Index fund (NYSEARCA:IYY). This ETF owns shares in 1,244 of the largest U.S. companies and a list of the fund's holdings can easily be downloaded from the iShares website. Thus, the fund gives us a good proxy for determining what median valuations currently are. To ensure an apples-to-apples comparison, I eliminated any companies missing current-year and prior-year price-earnings (P/E) or price-to-book (P/B) ratios. For today's commentary, I re-calculated the data on the remaining 1,018 companies as of August 9, 2013 to include data from a greater number of second-quarter 2013 earnings reports.

The median price-earnings ratio for this group of stocks is 20.8, versus 16.8 a year ago. The median price-to-book ratio is 2.7, versus 2.3 a year ago. The increases in the two ratios are indicative of multiple expansion. Investors are now willing to pay more for every dollar of earnings or book value than they were a year prior.

Since these are median numbers, they differ from the valuations you will see typically quoted for the market. The S&P 500, the Dow Jones U.S. Index and many other indexes are market-cap weighted, with larger companies having a bigger impact on both the indexes' price movement and valuations. This is why iShares can list a P/E of 22.3 for IYY (as of July 31, 2013), I can calculate a P/E of 20.8 and both of us can be right. Though a lengthy argument can be made about which measure is better, they're really just two ways of looking at the same thing. Median stock valuations give insight into what is available for stockpicker to buy, while market-cap weighted valuations give insight into whether the market is cheap or expensive overall.

As to whether you should be concerned about the multiple expansion, Liz Ann Sonders said the answer is no. In a report issued earlier this week, the chief investment strategist for Charles Schwab says the current S&P 500 (market-cap weighted) price-earnings ratio of 17.2 is below the median P/E ratio of 18.7 at which bull markets lasting more than one year have ended. Furthermore, only four out of the prior 13 bull markets ended with a P/E below current levels (1935-1937, 1947-1948, 1949-1956 and 1974-1980), according to the data, dating back to 1928, she used from Bespoke Investment Group.

The current occurrence of prices rising at a time when earnings growth is slowing is also not unusual for bull markets in their third trimester, which Sonders says we currently are in. Rather, she said that this has "been the norm over the past 60 years. We typically see the largest amount of multiple expansion when earnings growth is slowing, not when it's accelerating, also typical in bull markets' third trimesters."

None of this guarantees stocks will go higher in the near term; in fact, even Sonders started her commentary by calling the market "vulnerable" to a pullback. What the data does tell you is that higher valuations are not by themselves a reason for worry. They do, however, show the importance of being selective and making sure you are adequately compensated for the risks you incur within your portfolio.

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. I have no business relationship with any company whose stock is mentioned in this article.