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Summary

  • The market is expensive in view of the context of the past six or ten years, but in the context of the past twenty-one years, it is inexpensive.
  • The markets have been expensive outside of recessions and significant slow-downs over the past several years, so the present market levels represent the customary abnormal normality.
  • With the economy chugging along in a satisfactory manner, perhaps the bull will age. But a bear now - maybe not.

There is consensus that the market is expensive. And perhaps in view of the context of the past six or ten years, it is. But in the context of the past twenty-one years, it is not terribly expensive.

This chart below lists out S&P 500 operating earnings, the year high, low and close, and the TTM high, low and close PE ratios over the twenty-one years ended 31 December 2013.

Source: MaxKapital Archives

Based on S&P 500 operating earnings, over the past twenty-one years the S&P 500 has closed at an average PE [TTM] of 19.20 (Median 17.91), having reached an average high point of 20.84 (Median 18.76), and an average low point of 15.80 (Median 14.86) over the course of the year. The average for the Hi/Lo/Close is 18.62 on average and 17.18 at median levels.

Source: MaxKapital Archives

The S&P 500 closed 6/12/14 at 1,943, a multiple of 17.86 times TTM operating earnings for 3/31/14. Since much of the second quarter of 2014 is behind us, it is fair to observe that the S&P 500 closed 6/12/14 at 1,943, a multiple of 17.37 times TTM operating earnings expected for 6/30/14. While these levels do look expensive to what we have been accustomed to over the past six and ten years, they are very consistent with median close levels seen over the past twenty-one years.

S&P 500 operating earnings for the year ended 3/31/14 came in at 108.85. Based on the historic twenty-one year multiples, this is the range of values we could have reasonably expected to see during the year ended 3/31/14. The market closed 3/31/14 at 1,872: within a whisker of the average median 21 year level.

Source: MaxKapital Archives

For the trailing twelve months to 6/30/14, I am looking for S&P 500 operating earnings of $111.94. This estimate is based on S&P's bottom estimates which can be downloaded here. These are the indicative values based on twenty-one year multiples.

Source: MaxKapital Archives

The S&P 500 recently traded at 1,943, which leaves a downside of 1.1% to average indicative median levels and an upside of 8% to the median Hi levels. Earnings season is not far: in two weeks or so the quarter ends. Expectations for the quarter ended 6/30/14 are at 29.45. And in my view, as usual, the bar has been set low. For this reason, I feel that it is possible that what we have seen in recent days is a buyable dip, with a short-term target of 2,000.

For the trailing twelve months to 12/31/14, I am looking for S&P 500 operating earnings of 119.65. This estimate is based on S&P's bottom up estimates. These are the indicative values based on twenty-one year multiples.

Source: MaxKapital Archives

As you can see, with the markets at 1,943, there is plenty to play for. There is six month upside of 5.7% to average indicative median levels, and a six month upside of 10.3% to the median close levels.

For the trailing twelve months to 12/31/15, I am looking for S&P 500 operating earnings of 137.30. This estimate is based on S&P's bottom up estimates. It is worth noting that the bottom up estimate is lower than S&P's top down estimates of $148.19. These are the indicative values based on twenty-one year multiples.

Source: MaxKapital Archives

Once again, there is plenty to play for. There is an eighteen month upside of 21.3% to average indicative median levels, and an eighteen month upside of 26.5% to the median close levels.

Many will argue that the earnings estimates are ridiculous. After all for earnings to grow from 107.3 in 2013 to 137.3 in 2015 suggests an annualized growth rate of 13.1%. And that is overly optimistic. I don't see earnings contracting ahead as there are no recession signs visible. And I feel comfortable with a long-term annualized growth expectation of 6% to 6.5%. Thus, I expect earnings excluding the impact of buybacks to grow to 120 by 2015. Including the impact of buybacks, I expect 2015 earnings to approach 125. Based on 125 in 2015 earnings, there is an eighteen month upside of 10.4% to average indicative median levels, and an eighteen month upside of 15.1% to the median close levels. Add the 3% you will receive in dividends during the eighteen months, and there is still everything to play for, especially considering the alternatives outside equity as an asset class.

The markets are expensive today. Thus, there is no reason to be over-weight on equity allocations. But markets are no more expensive than they have been over much of the past twenty-one years. The markets have been expensive outside of recessions and significant slow-downs over the past several years, so the present market levels represent the customary absurd abnormal normality! And so there is no reason to be under-weight equity allocations either.

With the economy chugging along at an even keel, there is little reason to be under-weight equity until leading indicators start signaling trouble ahead. Risk appetite levels could change rapidly with expectations of interest rates rising, but that is expected to be a 2016 event to which markets will respond between mid-late 2015.

How to participate if you are fearful

So far this year, on a total return basis, the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) has outperformed the iShares Russell 2000 ETF (NYSEARCA:IWM), but has underperformed both SPDR S&P 500 ETF (NYSEARCA:SPY) and Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP).

If you find yourself tending to fear, you are not alone: seek refuge in the Dow. According to the SPDRs State Street Global Advisors website, the SPDR Dow Jones Industrial Average ETF provides a yield of over 2%, with a forward 1 year PE Ratio of 15.18 and five year earnings growth expectations of near 10%. That is not expensive.

Source: SPDR State Street Global Advisors

You can do better by investing directly in Dow stocks. According to the SPDRs State Street Global Advisors website, as you can see, simply replicating the Dow as weighted in the index, you would improve on the dividend yield in comparison to buying the ETF. In addition, you would buy the rights to future performance at a PE (TTM) of 16.35 and a Price to Cash flow of 10.47, with a very strong return on equity of 26.56%.

Source: SPDR State Street Global Advisors

And you could do better still using stock selection or a simple strategy such as the Dogs of the Dow, be it the big dogs or the small dogs. The big dogs stocks strategy which I set up and have been tracking since the start of the year is certainly outperforming the SPDR Dow Jones Industrial Average ETF so far. The total returns (including only cash dividends received to date, assuming no re-investment), for the equal weighted Dogs has been 5.26%, compared with 2.1% for the SPDR Dow Jones Industrial Average ETF.

Source: MaxKapital Archives

Or you could make your own selection from among the Dow stocks. This is a list of Dow stocks sorted by dividend yield (high to low). The list also displays beta, so if you are feeling particularly fearful, steer clear of the high beta names. And if you are quaking in fear, perhaps you could also eliminate stocks with a relatively low free float market capitalization: say anything below the mega-cap threshold of $100 billion.

Source: MaxKapital Archives

Stay allocated. The markets are expensive, but I doubt it is time for a bear.

Disclosure: The author is long VZ, PFE, INTC, GE, PG, CSCO, MRK, MSFT, JNJ, WMT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

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