The Markets Are Not Cheap, But They're Not Expensive Either

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Includes: AAPL, CAT, CVX, DD, DIA, DIS, GE, GOOGL, GS, IBM, IWM, JPM, KO, MRK, QQQ, SPY, T, TRV, V, VZ, WMT
by: Shiv Kapoor

Summary

S&P 500 closed July at 1,930, down 1.51% for the month. Has the market commenced a bear market (20% or more downside from the peak of 1,991)?

Or is this the start of a correction (up to 10% downside from the peak of 1,991)?

While the S&P 500 is not cheap, it is not particularly expensive either.

On the other hand, mega-caps making up 35% of the free float market capitalization of the S&P 500 are cheap.

In my view, I suspect today's aggressive sellers may find themselves regretting their decision to sell in six months’ time.

The S&P 500 closed July at 1,930, down 1.51% for the month - with the S&P 500 declining 2% on 7/31/14, all of the damage was done on the last day of the month! The Dow Jones Industrial Average fared slightly worse, closing at 16,826, down 1.56% for the month. Has the market commenced a bear market (20% or more downside from the peak of 1,991), or is this the start of a correction (up to 10% downside from the peak of 1,991)? In my view, I suspect aggressive sellers may find themselves regretting their decision to sell in six months' time.

The S&P 500 has a free float market capitalization of near $17 trillion. About 29.5% of the free float market capitalization is covered by Dow stocks. A further 5.3% is covered between Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOGL). Thus between Dow stocks and two mega-cap stocks, we cover near 35% of the free float market capitalization of the S&P 500. The points I am hoping to make are:

  1. While the S&P 500 is not cheap, it is not particularly expensive either.
  2. About 35% of the free float market capitalization of the S&P 500 is collectively quite inexpensive.

The S&P 500 is not cheap, but it is not particularly expensive either

The S&P 500 is trading at a trailing twelve month PE of 18.47. 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. Thus with the S&P 500 PE ratio at 18.47, the index does not look particularly expensive.

However, if I eliminate 98 to 02, the main exuberance years over the past 21 years, I get Median Hi/Lo/Close/Average multiples of 17.38, 14.15, 17.27, and 16.28 respectively. With the S&P 500 PE ratio at 18.47, it is clear that the index is not cheap.

Overall, I cannot get myself to see a market trading at a forward year PE of 16.47, with 3 to 5 year earnings growth expectations of near 11.5%, a return on equity of over 22%, and a dividend yield of 2% as expensive. And my pro equity bias is further strengthened by US ten year government securities which yield only 2.5% today. If bond yields don't rise, equity markets probably won't decline dramatically, and if bond yields do rise, we might see some downside in equity, but possibly no worse that the losses to long duration bonds. There are always short duration bonds and cash to shelter in. And in my view holding up to 30% of your portfolio in short duration bonds is no bad thing to do. This allocation will protect you from a decline in equities, and provide you with the liquidity to invest in equity should the market decline be dramatic.

S&P 500

Source: SPDR® S&P 500® ETF

The Dow Jones Industrial Average on the other hand is quite inexpensive. Overall, I cannot get myself to see the Dow Jones Industrial Average, which is trading at a PE of 15.95, a forward year PE of 14.92, with 3 to 5 year earnings growth expectations of near 10%, a return on equity of over 27.5%, and a dividend yield of 2.29% as expensive. In fact, it is cheap. And when you consider the low beta relative to the S&P 500, it is even cheaper on a risk adjusted basis.

Dow Jones Industrial Average

Source: SPDR® S&P 500® ETF

Non Dow Mega-caps

Google which trades at a trailing twelve month PE Ratio of just over 30 does look expensive, but it is not, after we consider growth expectations of near 17% over the coming five years, together with the companies track record in delivering solid earnings growth.

Source: Reuters

Apple which trades at a trailing twelve month PE Ratio of just over 15.85 does not look expensive, especially after we consider growth expectations of over 12% over the coming five years.

Source: Reuters

If 35% of the free float market capitalization of the S&P 500 can be said to be collectively inexpensive, I feel fairly confident in saying that in a worst case scenario, markets are expensive, but all stocks are not. I would consider a dip on the S&P 500 to 1,850 a reasonably attractive buying opportunity. Having said that, I don't believe the market should fall much below 1,922 - at least not without evidence of a widespread and substantial slowdown in the coming months.

A Closer Look at the Dow Jones Industrial Average

In this section, I look at the Dow Stocks through the eyes of Value-Line Research. The markets are expensive, but several Dow stocks still offer very decent return potential, together with a considerable alpha opportunity. The column titles marked (1) on this table come from Value Line Research. The rest of the column titles are simple arithmetic.

Source: MaxKapital Archives

Using the mid-point of the Value Line price targets, twenty-six of thirty Dow stocks offer alpha, or excess return as priced. The four stocks offering negative alpha are Caterpillar (NYSE:CAT), Chevron (NYSE:CVX), Disney (NYSE:DIS) and Merck (NYSE:MRK).

Holding an equal-weight portfolio of Dow stocks offers a three year annualized total return potential of at least 8.3% with an upside to 16.46%. The expected value of the total return at the mid-point of hi and low targets offers a three year annualized total return potential of 12.55%.

Using the mid-point of the Value Line price targets, the annualized average total return expectation from the 26 stocks offering alpha or excess returns equal weighted is generous at 13.70%. There are twelve stocks offering a total return potential of over 14% using the mid-point of Value Line's target prices. These include Verizon (NYSE:VZ), Goldman Sachs (NYSE:GS), IBM (NYSE:IBM), AT & T (NYSE:T), Travelers (NYSE:TRV), Du Pont (NYSE:DD), General Electric (NYSE:GE), JP Morgan (NYSE:JPM), Visa (NYSE:V), Walmart (NYSE:WMT), and Coca Cola (NYSE:KO).

The average annualized total return expectation using Value Line's Hi targets is 16.46%. The average annualized total return expectation using Value Line's Lo targets is 8.3%. The annualized average total return expectation from all 30 stocks equal weighted using the mid-point of Value Line's target prices is generous at 12.55%.

So yeah, the broad markets are expensive, but there is plenty of opportunity out there for long-term investors.

By the way, don't squint at this chart: your eyes will hurt! Right click on the picture and open it in a new tab and you'll be able to view the data much better.

Most of the column data titles are self-explanatory. Some require further explanation, and this is how Value Line describes what they mean. For the record, Value Line publishes data for Dow stocks free. Value Line are, in my opinion, by far the best data service for U.S. listed stocks: anyone with a portfolio worth $1 million or over would do well to subscribe, and frankly smaller sized portfolios can benefit too. And for those who might be interested, Value Line presently has a two week free offer - I'd recommend signing up strongly. For the record, I have nothing to do with Value Line other than loving what they do for the self directed investor!

The TimelinessTM Rank measures the probable price performance of a stock relative to the approximately 1,700 other stocks covered by The Value Line Investment Survey® during the next six to twelve months.

The SafetyTM Rank measures the total risk of a stock relative to the approximately 1,700 other stocks covered in The Value Line Investment Survey®.

Financial Strength Rating: Value Line classifies 1,700 companies' Financial Strength ratings from A++ to C, in nine steps. The lowest grade is reserved for companies experiencing serious financial difficulty. Balance sheet leverage, business risk, the level and direction of profits, cash flow, earned returns, cash, corporate size, and stock price, all contribute to a company's relative position on the scale. The amount of cash on hand, net of debt, is also an important consideration.

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