On many of the down days in the market that we have had over the past few months, you hear journalists ask their guests the same question: Are you buying the dip? What they are trying to find is an opinion on market-wide equity valuation.
As an investor, I am of course deeply interested in the concept of valuing the stock market as a whole. Though my investment style is certainly more "bottom-up" than "top-down", as my fund holds securities which I perceive to be undervalued based on their individual merits rather than a determination of the valuation of the market as a whole, I would be foolish to believe in the inability of the broader market trends to impact my holdings. Accordingly, maintaining a stance on market valuation is fundamentally important.
The following is an examination of what I believe to be fair-value for today's market and the criteria I use to arrive at that valuation.
An Overview of Today's Economy
Let's examine today's economic landscape by looking at the individual factors.
Low Interest Rate Environment
As the QE program has driven the U.S. 10 Year Treasury Rate to fall from nearly 5% to under 2.5%, today's low interest rate environment has resulted in the following:
- Lower cost of capital for businesses, increasing lending, spurring growth. This results in higher equity multiples.
- Stocks become significantly more attractive than fixed income. This also results in higher equity multiples.
- Increased lending to consumers. This boosts housing and automobile sales, among other things.
Low Fuel Costs
WTI Crude has fallen from $100 a barrel to $60 over the past year. This has resulted in the following:
- Boost for consumers who are getting a net bonus.
- Boost for companies that use fuel as an operating expense.
- Detriment for companies near the energy sector, which has been one of the larger if not the largest driver of employment growth in the U.S. recently, and especially for the employees of those companies.
Domestic Economic Landscape
The aim of the Federal Reserve has been to maximize employment and maintain 2% inflation. Here's what has happened so far:
- Unemployment Rate has dropped to 5.5% from 9.8% in the beginning of 2010, but has yet to drop below the 5% level seen in 2008 and the 4% level seen in 2000.
- U.S. Labor Force Participation Rate is lower that it has been since 1978.
- Current U.S. GDP Growth Rate of 3.91% and Real GDP Growth Rate of 2.99% are roughly flat since 2011.
- Retail Sales Growth has declined significantly since 2011.
- Home prices are flat from 2002.
- Goal is 2% inflation, but the last four months have been deflationary.
- Wage growth - as seen through the Employment Cost Index (ECI) - is on the rise but are still below the 3.5% growth averages seen from 2001-2007. Last quarter saw 2.6%.
Domestic Corporate Landscape
- S&P 500 Earnings per Share (EPS) is at an all time high.
- S&P 500 Sales per Share (SPS) is at an all time high.
- Companies continue to believe their stocks are undervalued as they are repurchasing shares at an unprecedented rate.
- The strength of the USD is proving to be a headwind for companies with overseas operations.
Global Economic Landscape
- Europe is facing a recession - or at least the EMF believes so as Europe is beginning QE.
- The PIGS nations (Portugal, Italy, Greece and Spain) are in crises.
- Japan's economy is struggling - perhaps the best modern example of failed economic stimulus.
The S&P 500 looks expensive on traditional basis.
- Trailing P/E of 20.52 is highest since 2010.
- Shiller P/E of 27.07 is highest since 2007.
- Price to Book of 2.89 is highest since 2004.
- Price to Sales of 1.80 is highest since 2001.
- Forward P/E of 16.9 is highest since 2004.
- PEG ratio of 1.6 is highest since 1995.
What is Making the S&P 500 Look Expensive?
The S&P 500 - at less than 5% away from its all time highs - is the most expensive it has been in a decade when examined through the lens of traditional valuation multiples (Price-to-Earnings, Price-to-Book, Price-to-Sales, Price-to-Earnings-to-Growth, etc.). I'm interested in why. Which sectors are responsible for inflating the S&P 500's multiples?
Sector-specific forward P/E multiples are as follows:
- S&P 500: 16.9
- Consumer Discretionary: 18.9
- Information Technology: 16.2
- Telecommunication Services: 13.5
Of the ten sectors, the four that have Forward P/E multiples higher than the average are: Consumer Discretionary, Consumer Staples, Energy, and Health Care.
Consumer Discretionary: 18.9
Within Consumer Discretionary, there are fifteen sub sectors. Of the fifteen, four trade at Forward P/E multiples higher than the sector average:
- Casinos: 22
- Restaurants: 23.7
- Footwear: 25.6
- Home Improvement Retailers: 20.1
Consumer Staples: 19.2
Within Consumer Staples, there are seven sub sectors. Of the seven, four trade at Forward P/E multiples higher than the sector average:
- Household Products: 19.3
- Packaged Foods: 20.2
- Personal Products: 26.3
- Soft Drinks: 20.3
Within Energy, there are five sub sectors. Of the five, two trade at Forward P/E multiples higher than the sector average:
- Oil & Gas Equipment & Services: 25.8
- Oil & Gas Exploration & Production: 45
Health Care: 17.4
Within Health Care, there are six sub sectors. Of the six, two trade at Forward P/E multiples higher than the sector average:
- Health Care Equipment: 18.8
- Health Care Distributors: 19
Sector-specific PEG ratios are as follows:
- S&P 500: 1.6
- Consumer Discretionary: 1.26
- Consumer Staples: 2.47
- Energy: 3
- Financials: 1.2
- Health Care: 1.61
- Industrials: 1.51
- Information Technology: 1.36
- Materials: 1.58
- Telecommunication Services: 2.02
- Utilities: 3.25
Of the ten sectors, the five that have PEG ratios higher than the average are: Consumer Staples, Energy, Health Care, Telecommunication Services, and Utilities.
The sectors that have Forward P/E multiples and PEG ratios that are each higher than the S&P 500 average are:
- Consumer Staples: 19.2, 2.47
- Energy: 24.9, 3
- Health Care: 17.4, 1.61
On this basis, I perceive these three sectors as being the most expensive within the S&P 500 as well as being chiefly responsible for the Index appearing expensive. Stabilization in energy prices combined with wage inflation should help increase earnings in these sectors and ultimately lower their respective multiples.
Simply recognizing that the S&P 500 as a whole appears expensive is less important than an understanding as to why. The Consumer Staples, Energy, and Health Care sectors are leading the charge in inflating valuation metrics for the index, but there are certainly other reasons.
- The strength of the American economy makes American companies more appealing relative to the rest of the world. This inflates U.S. equity multiples.
- In a low interest rate environment, companies hoard cash. This has the effect of inflating equity multiples. When cash is excluded, we find the Non-Cash P/E is less than 12.
- As I have previously discussed, equity multiples trade inversely to the risk-free rate. For a complete understanding as to why, please read this article I wrote a few months ago. In it, I describe what I call the "Ideal P/E multiple", which is simply the inverse of the risk-free rate where the risk-free rate is the combination of the U.S. 10-Year Treasury Yield and the S&P 500 Dividend Yield. Over the past three decades, differences between the Ideal P/E multiple and the actual Forward P/E multiple have dictated the change in the S&P 500 Index in both direction and in magnitude. (See Chart Below) Accordingly, as yields are driven to all time lows, it should not be surprising to see inflated equity valuation multiples.
Growth is an important valuation factor. Current Year and Next Year growth expectations are as follows:
- 2015 EPS growth expected in every sector except Energy.
- 2015 S&P 500 EPS growth estimate of 1.6%.
- 2016 EPS growth expected in every sector.
- 2016 S&P 500 EPS growth estimate of 12.1%.
- 2015 S&P 500 EPS estimate of 119.80.
- 2016 S&P 500 EPS estimate of 134.19.
Interestingly, examining the 25 largest weighted holdings in the S&P 500 Index (Note: These 25 companies account for 31% of the Index), we see that 2015 EPS growth estimates are expected to be higher than 10.5% YoY, and 2016 EPS growth estimates are excepted to be nearly 36% YoY.
- Despite the significant downturn in the energy sector brought on by the precipitous decline in energy prices, despite the resulting deflationary pressures, job losses, and cuts in earnings forecasts, the S&P 500 is still expected to grow earnings in 2015 on a year-over-year basis. What's more, 2016 is expected to witness double-digit EPS growth.
- The energy sector, one of today's chief inflators of valuation metrics in the S&P 500, is expected to have robust EPS growth in 2016. Should this prove true, the sector (and accordingly the Index) may become significantly less expensive on a Forward P/E and a PEG basis.
- With Europe beginning its QE program, European rates are expected to remain subdued. This should pressure the Fed to act gradually in raising rates domestically. This may keep equity multiples inflated.
- Economic growth as seen through unemployment, GDP growth, labor force participation, retail sales, housing prices, inflation data, and wage growth tells a story of gradual - yet relatively consistent - improvement.
Valuing Today's Market
The relevant figures are:
- U.S. 10-Year Treasury Yield: 2.32%
- S&P 500 Dividend Yield: 1.94%
- Effective Risk-Free Rate: 4.26%
- Resulting Ideal P/E Multiple: 23.47
- 2015 S&P 500 EPS Estimate: 120
- 2016 S&P 500 EPS Estimate: 134
Adhering strictly to the Ideal P/E Multiple would suggest a fair value for the S&P 500 of 2,820, roughly 34% higher than today's 2,100 level. However, the following adjustments need to be made:
- Fair-Value Forward P/E should be discounted because of the relatively lackluster 2015 EPS growth estimates. This is somewhat offset by the strong 2015 EPS growth estimates for the top 25 companies in the Index as well as the universally strong 2016 EPS growth estimates.
- Fair-Value Forward P/E should be increased because the cash hoarding by companies makes multiples appear more expensive.
- Fair-Value Forward P/E should be discounted due to global economic weakness and uncertainty.
- Fair-Value Forward P/E should be discounted due to the slower than expected domestic economic recovery.
- The Ideal P/E should be recalculated based on the expectation of higher treasury yields. Assuming the U.S. 10-Year Treasury Yield rises to 2.50% from 2.32%, the resulting Ideal P/E multiple is 22.5.
In light of the above, I believe a 10% to 15% discount to the recalculated Ideal P/E multiple is appropriate. This results in a Fair-Value Forward P/E of 19.75 times 2015 EPS. Accordingly, I believe fair value for the S&P 500 to be around 2,400, roughly 14% higher than today's 2,100. So would I buy the dips? I certainly would.