ETF Trade Ideas From Valuation Trends

Includes: IWM, SPY
by: Michael Krause

Note: The following article illustrates how investors might use new charts on Historical Valuation Trends in the ETF Analyzer PREMIUM app to find and research ETF trade ideas.

We've added some enhancements to the ETF Analyzer PREMIUM app (try it free) to assist investors in conducting fund analysis. After launching the app, enter a ticker symbol as usual and click on the ‘Investment Merit’ tab, then scroll down to see four new charts showing each fund’s historical:

  • Price-to-earnings ratio (P/E)
  • Price-to-sales ratio (P/S)
  • Price-to-book value ratio (P/BV)
  • Dividend yield (Yield)

Each chart shows monthly data going back to 2006 (or since inception for younger funds) using twelve months’ forward figures for earnings, sales, book value or dividends per share. Mouse-over the charts for individual data points. Unlike the ALTAR Score™ rating which is our estimate of how a fund should trade, these figures show how a fund is trading in relation to its recent past.

So what are the benefits and limitations of historical valuation trends in assessing ETFs? Let’s start with a few limitations. The P/E of the S&P500—unique in having such a lengthy history—has varied widely from as low as 7.1x to as high as 31.5x since 1950 (Figure 1). Logic would suggest that whatever the level it should be more consistent given that over the same time frame 98% of S&P earnings can be explained by a single factor: the passage of time.

Instead, the P/E has stayed at elevated or depressed levels for a decade or more until suddenly there was a shift. This seems to mirror changes in economic era, for example when inflation was high in the 1970s depressing P/Es, or during the Tech bubble of the 1990s when it was generally assumed that rapid growth would continue indefinitely, and valuations didn’t matter.

To complicate things, it seems as if the financial crisis and the bear market of 2008-09 represent another such shift in economic era, if less dramatic that previous shifts. Since the bear market low, the market P/E has oscillated between 11.3x and 13.6x, seemingly bouncing off either extreme multiple times (Figure 2).

And therein lies one of the strengths of this analysis. Over shorter time frames of a few years instead of decades, recent trends in valuation may serve as a useful guide to how the ETFs may trade so long as there isn’t a major economic shift. Potentially, the most powerful rallies are likely to come from areas where there is both underlying growth in earnings (or sales, etc.) and room for multiple expansion without breaking new ground. Conversely, multiple contraction could cancel out any improvements in underlying growth, or worse. The S&P 500 SPDR (NYSEARCA:SPY) trading near the top of its “new normal” range suggests that further upside may be limited to earnings growth or less.


Figure 1: Forward P/E Multiple

S&P500 index, 1950-present, quarterly

Source: AltaVista Research

Figure 2: Forward P/E Multiple

S&P500 SPDR (SPY), 2006-present, monthly

Source: AltaVista Research

Of the four valuation trends, we prefer price-to-sales and price-to-book value as measures that are less volatile and less subject to manipulation. In any case it should be noted that it is both normal and logical that different indices may sustain different levels for a particular valuation metric, due to differences in sector balance or geographic allocation, among other factors.

For example, small cap stocks in the iShares Russell 2000 fund (NYSEARCA:IWM) have an average price-to-sales ratio of 0.8x since 2006, compared with 1.3x for their large cap counterparts in SPY. That doesn’t mean that stocks in IWM are cheap; given the fund’s sector breakdown it also has lower profit margins. But changes in the relative valuation levels between these two asset classes may be enlightening.

IWM has far outperformed SPY since the start of 2006, returning 34% and 19%, respectively. However this is not because firms in IWM have been able to grow sales (or earnings, dividends or book value) any faster; in fact, they’ve done worse over that period (Figure 3).

Figure 3: Compound Growth Rates

SPY vs. IWM, 2006-11E

Source: AltaVista Research

Rather, the outperformance of the small caps is due to their increasingly aggressive valuation multiple relative to their large cap counterparts. Specifically, whereas the price-to-sales ratio of SPY has merely recovered to its average level since 2006, the price-to-sales ratio of IWM is at bumping up against pre-crisis highs as if there is no “new normal” for small caps. In other words, the ratio of the P/S multiple of IWM to that of SPY has been trending markedly upwards (Figure 4).

Figure 4: Relative Price-to-Sales Multiple

IWM P/S divided by SPY P/S, 2006-present

Source: AltaVista Research

At a minimum we can say that, collectively, investors think stocks in IWM now deserve a higher relative multiple than they thought was the case five years ago. Obviously opinions make a market, but in our opinion this trend cannot persist forever, and it may well reverse. That suggests that—whatever the direction of the market in general—large caps may be positioned to outperform small caps over the next few years, even if the latter manage to grow sales a bit faster in 2011-12E as forecast.

Hopefully, historical valuation trends can assist ETF investors in making shorter-term tactical trading decisions as opposed to the very long-term, strategic asset allocation decisions that the ALTAR Score™ rating is intended to inform. With four charts for each of the 600+ ETFs we cover, there are over 2,400 new analytical tools available. What trade ideas will you discover?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.