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David Moenning is a the Chief Investment Officer at Heritage Capital, which focuses on active risk management of the U.S. stock market. Dave is also the proprietor of StateoftheMarkets.com, which provides free and subscription-based portfolio services. Dave began his investment career in 1980... More
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Daily State of the Markets
  • The Market Math On Valuations 0 comments
    Jan 15, 2014 8:20 AM

    Daily State of the Markets
    Wednesday, January 15, 2014

    Apparently all those traders (and their computers, of course) that were spooked on Monday when Goldman Sachs said that stocks were overvalued, took solace on Tuesday from another report out of Goldman's wealth management department which told investors to stay long. Although Tuesday's report from GS was not overly bullish (Goldman says stocks could eek out a gain of 3 percent this year), it did seem to counteract the prior day's call to head for the hills. As such, the algos went the other way on Tuesday and the dip-buyers appeared to regain some confidence.

    Such is the state of the stock market these days where one day the computers are negative and the next, well, not so much. And with the indices currently in a fairly defined trading range, it will be interesting to see which team emerges victorious and retains possession of the ball.

    So, with the near-term direction in the market a question mark at this stage, we thought it would be a good idea to continue on with our "market math" series.

    The final indicator set in our review of what we call "market math" is market valuation. But before we get to the question of whether or not stocks are over-, under- or fairly-valued, we thought it would be a good idea to step back and review what we've learned so far.

    "Don't Fight the Fed"

    First, we explored monetary conditions, which, in trader parlance, is also commonly referred to as "Don't fight the Fed." Here, we learned that interest rates have been a major contributing factor to stock prices over the years. And we observed that currently the Fed remains a bull's best friend.

    "Don't Fight the Tape"

    Next, we looked at the "state of the tape," meaning that we explored some of our favorite trend and momentum indicators ("Don't fight the tape" has long been a vital Wall Street-ism for investors to follow). As anyone who has owned a stock over the past couple of years probably recognizes, the trend has also been a stock market investor's friend. However, we noted that the market's momentum has been waning lately, which can be viewed as a warning sign at this time.

    External Factors: Sentiment Flashing a Warning

    Then we started looking at the "external factors" of the market such as the economy, inflation, and investor sentiment. We learned that the economic model is currently neutral but that stocks tend to perform a bit better than average when the model is in this mode. We learned that inflation is nowhere to be seen at the present time but that if this indicator starts to perk up, it would be a very good idea to pay attention.

    We also spent some time talking about investor sentiment and how important it is to know how to use these indicators. The bottom line here is that every single one of our important sentiment indicators is currently flashing red - bright red. As such, investors may want to take their foot off of the gas and play the game a bit more conservatively than normal.

    Now let's move on to our final "external factor" - market valuation - and see if stock prices might be getting a bit lofty.

    Valuation Lies In The Eyes of the Beholder

    Perhaps the most important thing to understand about valuation indicators is that valuation lies in the eyes of the beholder. Two analysts can look at the exact same set of indicators and come up with different conclusions as to whether or not stocks are over-, under-, or fairly valued.

    The Problem with Valuation Indicators Now

    This is especially true in the current environment. The problem is that traditional valuation indicators such as the Price-to-Earnings (P/E) ratio stayed in a fairly definable range for 70 years. However, first the technology bubble and then the credit crisis caused the range to expand - wildly.

    For example, if one looks at the S&P 500's P/E ratio using GAAP (generally accepted accounting principles) earnings, the range from 1925 through 1995 was fairly definable. P/E's below 11 were considered to be "cheap" while anything over 16.5(ish) meant that stocks were considered "expensive."

    The Data Has Been Skewed

    However, since 1995, the GAAP P/E ratio has been under 16.5 only once. And then on the upside, the GAAP P/E was over 30 in 1998/99, over 40 in 2001/02, and was above 125 in 2009!

    So, the question now becomes, what level is overvalued? Sure, the 2000 and 2009 readings were artificially inflated. But the data from 1995 makes an historical analysis difficult at best.

    From 1925 through 1995, the average GAAP P/E was somewhere around 14. The average for the full period is about 17. The average for the last 50 years is 19.2. And the average over the last 25-years is nearly 25 - a level that was never once hit prior to 1990!

    Therefore, it is very difficult to make a call on valuation these days without starting your assessment with a disclaimer and forming an opinion of what "normal" is at the present time.

    What's the Current GAAP P/E?

    Currently, the GAAP P/E for the S&P 500 is 19.11 (as of 12/31/13). But the problem is we can't really tell whether this is high, low or indifferent due to the wild swings seen over the past 20 years.

    Using the full-period data, one can argue that stocks are now expensive. Using the last 50 years of data, the GAAP P/E is isn't even above average (19.1 vs. 19.2). And using the last 25 years of data, one can argue that stocks are remain downright cheap as the current 19.1 reading is well below the average of 24.9.

    Therefore, using a very traditional measure of valuation, an investor can make any argument they'd like. And frankly, THIS is the reason that valuation indicators are not used in our Market Environment Model. In short, there is simply too much subjectivity involved these days.

    Tomorrow, we will take a look at an alternate approach to valuations - a relative valuation model.

    Looking for a disciplined approach to managing stock market risk on a daily basis? Check Out My "Daily Decision" System. Forget the fast money and the latest, greatest option trade. What investors need is a strategy to keep them "in" the stock market during bull markets and on the sidelines (or short) during bear markets.

    Turning to This Morning...

    A report that the World Bank has upped global growth estimates as well as upbeat earnings from Bank of America has traders in a decent mood so far. Asian markets followed Wall Street's lead higher and European bourses are also green across the board this morning. U.S. futures currently point to a modestly higher open here in the U.S.

    Pre-Game Indicators

    Here are the Pre-Market indicators we review each morning before the opening bell...

    Major Foreign Markets:
    - Japan: +2.51%
    - Hong Kong: +0.49%
    - Shanghai: -0.19%
    - London: +0.43%
    - Germany: +1.35%
    - France: +0.70%
    - Italy: +1.00%
    - Spain: +0.35%

    Crude Oil Futures: +$0.27 to $92.86

    Gold: -$8.30 to $1237.10

    Dollar: lower against the yen, higher vs. euro and pound

    10-Year Bond Yield: Currently trading at 2.870%

    Stock Futures Ahead of Open in U.S. (relative to fair value):
    - S&P 500: +3.48
    - Dow Jones Industrial Average: +32
    - NASDAQ Composite: +13.10

    Thought For The Day...

    I hear and I forget. I see and I remember. I do and I understand. -Confucius

    Positions in stocks mentioned: none

    Follow Me on Twitter: @StateDave


    The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of StateoftheMarkets.com and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment.

    Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

    The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

    The information contained in this report is provided by Ridge Publishing Co. Inc. (Ridge). One of the principals of Ridge, Mr. David Moenning, is also President and majority shareholder of Heritage Capital Management, Inc. (HCM) a Chicago-based money management firm. HCM is registered as an investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Ridge is a publisher and has not registered as an investment adviser. Neither HCM nor Ridge is registered as a broker-dealer.

    Employees and affiliates of HCM and Ridge may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.

    Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

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