Are Stocks Cheap Or Expensive? My Action Plan For 2019

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Includes: BIBL, CHGX, CRF, DDM, DIA, DMRL, DOG, DUSA, DXD, EDOW, EEH, EPS, EQL, EQWS, ESGL, FEX, FWDD, GOOG, GOOGL, GSEW, GVAL, HUSV, IVV, IWL, IWM, JHML, JKD, OMFS, OTPIX, PMOM, PPLC, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RVRS, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USA, USMC, UWM, VEU, VFINX, VOO, VTWO, VV, ZF
by: Andres Cardenal, CFA
Summary

There is clear conundrum in terms of valuation levels for US stocks.

Indicators such as CAPE ratio and price-to-sales signal that the market is aggressively expensive, or even downright overvalued.

On the other hand, prices are much more reasonable when based on current and expected earnings.

The short-term outlook ultimately comes down to what will happen to corporate margins and the economy in 2019.

Over the long term, high-quality growth stocks and international stocks look much more attractive than the broad US indexes.

Depending on what kind of valuation indicator you are looking at, you can either say that US stocks are excessively overvalued or reasonably priced. It ultimately comes down to how sustainable you think current earnings numbers are in the middle term.

When making investment decisions for 2019 and beyond, we need to be very selective in US stocks, and a healthy dose of international diversification makes a lot of sense for value-hunting investors.

The Valuation Disconnect

Some widely followed valuation indicators are saying that US stocks are priced at dangerously high levels.

The Cyclically Adjusted PE Ratio (CAPE Ratio) is a price-to-earnings ratio based on average inflation-adjusted earnings from the previous 10 years. The indicator is currently at 29.4, and it has not been this high since the levels before the Great Depression and the Tech bubble.

(Source: Multipl)

In case the CAPE ratio is not scary enough, the price-to-sales ratio looks even more extended. The market cap for S&P 500 stocks as a ratio of S&P 500 revenues, which is essentially the price-to-sales ratio for the index, is trading at historical highs, even materially above its highs from the dotcom bubble.

(Source Yardeni Research)

On the other hand, if we look at ratios such as trailing price-to-earnings, the U.S. stock market is not too expensive. Even more interesting, the forward price-to-earnings ratio based on 12-month forward consensus expected operating earnings is quite low, at 14.5. This is not only reasonable, but even attractive by historical standards.

(Source: Yardeni Research)

Why is it that stocks look dangerously expensive based on long-term earnings metrics and revenue, but they also look reasonably priced based on current and future expected earnings?

Profit margins are the key variable to consider. Due to relatively low wage inflation in recent years, cheap debt, cost-cutting technologies, and lower taxes, profit margins for companies in the S&P 500 have reached exceptionally high levels in the fourth quarter of 2018. This means that current earnings are at record highs in comparison to earnings over recent years, and earnings as a percentage of sales are exceptionally elevated too.

For this reason, the market is expensively valued in comparison to long-term earnings and revenue numbers, but far more moderately priced when looking at current and projected earnings.

(Source: Yardeni Research)

It would be easy to say that current and future earnings are the only things that should really matter. That is, if earnings and margins are higher today than in the past, then stocks are more valuable and historical comparisons don't really make much sense. But it's not that simple.

Profit margins tend to revert to the mean during recessions. Both stock prices and profit margins contracted substantially in periods such as 2001 and 2008.

If - or when - we get another recession, it's only safe to assume that profit margins could fall again, and current valuation levels for the S&P 500 do not offer much of a protection if margins and earnings start moving in the wrong direction.

This is a particularly relevant consideration nowadays, because many leading indicators for the economy are providing reasons for concern. The ECRI leading index, for example, is showing its lowest growth rate over the past 6 years. If we see further deterioration in the economic landscape, stocks are carrying a lot of downside risk from current levels.

Source: DShort

The Smart Way To Play This Market

If we can avoid a recession and a compression in profit margins over the coming quarters, then US stocks could continue performing well in 2019. Upside momentum has been really impressive since the market bottomed in December, so this scenario should not be discarded at all.

However, it's important to acknowledge that the market is relatively expensive from a long-term perspective, and the economic cycle in the US is quite mature. From current valuation levels, the main stock indexes could suffer severe drawdowns if the outlook for earnings deteriorates in a material way.

In this market environment, we want to be very selective when picking US stocks. The smart way to play this market is focusing on high-quality stocks with abundant long-term potential for growth and reasonable valuation levels.

Alphabet (GOOG, GOOGL) is an interesting example to consider. Wall Street analysts are on average expecting the company to make 47.17 in earnings per share during 2019. This means that Alphabet is trading at forward price-to-earnings ratio of 21.5.

Its valuation levels are above average, but financial performance is nothing short of impressive. Alphabet has delivered revenue growth at a compounded annual growth rate of 21.58% in the past three years, and the company makes an operating profit margin around 20% of revenue, with return on invested capital above 27%.

Alphabet is the undisputed leader in online advertising, thanks to the massive power of Google, and the company has abundant room for growth in areas such as YouTube, cloud computing, artificial intelligence, and a wide variety of futuristic technologies in its "other bets" division.

In other words, no matter what happens with the economy and the stock market in 2019, as long as Alphabet continues delivering in accordance with expectations, investors in the company should do well over the next 5-10 years. Even better, any short-term pullback in Alphabet stock will probably represent a buying opportunity for long-term investors in the company.

If you are simply looking to buy cheap stocks, the opportunities are far more attractive in international markets than in the US.

The table compares different valuation metrics for companies in the SPDR S&P 500 Trust ETF (SPY), the Vanguard FTSE All-World ex-US ETF (VEU), and the Cambria Global Value ETF (GVAL). The difference in valuations are quite wide, and investors can get much bigger bargains when hunting for opportunities in international markets, especially more if they focus on value stocks on a global scale.

SPY VEU GVAL
Price/Prospective Earnings 14.29 11.32 7.21
Price/Book 2.7 1.39 1.12
Price/Sales 2.02 1.09 0.8
Price/Cash Flow 11.75 4.44 3.86
Dividend Yield % 2.17 3.47 6.27

Data source: Morningstar

I'm not necessarily bearish on US stocks over the short term, but over the long term, the risk versus reward tradeoff for the US markets as a whole looks unattractive. In this scenario, being highly selective among US stocks and focusing on value opportunities in international markets sounds like a smart plan for 2019 and beyond.

Disclosure: I am/we are long GOOGL, GVAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.