Executive Summary: Investors should be cognizant that the recent pullback in the S&P 500 from all-time highs has been minimal in the context of the broader equity market performance in recent years. A fundamental, valuation-driven analysis suggests the S&P could correct to 1670, and a technical-driven analysis indicates a return to a similar level. Coincidence? Perhaps. But when most investors are expecting the same thing in the stock market, the stock market is usually quick to reflect the collective view of its participants (the Valuentum framework). The S&P 500 is trading at roughly 1750 at present, and we wouldn’t think anything of another 5% fall from current levels.
By Brian Nelson
The equity markets have certainly had a very nice run in the past few years to broader valuations that we continue to consider a bit lofty on an aggregate basis, even after the recent market pullback. Though many pundits believe that the S&P 500 remains on a path toward 2,000 by year-end 2014, we want you to stay realistic with your expectations and be prepared for further weakness. Let’s first examine what the fundamentals/valuation indicate, and then let’s check out what the technicals reveal, the latter more to gain perspective on where we are and how far we’ve come than anything else.
Fundamentals/Valuation
Though we acknowledge the pitfalls of using a price-to-earnings (P/E) ratio alone to ascertain individual and broader market valuation opportunities, we do believe that the equity markets are priced at a premium relative to the past, especially in the context of increasing global economic uncertainty (particularly in emerging growth markets—Turkey, Argentina, South Africa, and of course, China). According to FactSet (click here), the current 12-month forward P/E ratio is 14.7, above both the 5-year (13.1) and 10-year (13.9) averages.
We think a more reasonable fundamental, valuation-driven target for the S&P 500 on the basis of the forward P/E ratio is roughly 1670, or the 10-year average of the forward P/E (13.9) multiplied by the expected annual earnings per share on S&P 500 companies for calendar year 2014 ($120.09). Using the 5-year measure implies a lower target for the index, but the 10-year measure is more appropriate, in our view, because it captures a full economic cycle. One can also argue that the 10-year measure captures more generous expectations (higher multiples) in that it covers a period that spans the recovery of both the dot-com bubble and the Great Recession. On a forward P/E basis, it’s difficult to argue that a further correction is not coming. We probably wouldn’t be as worried by the relationship between the current forward P/E and its historical averages–as many could reasonably argue that even a 15 times forward earnings multiple for the markets isn’t completely absurd, given where interest rates are (the discounting mechanism for earnings/cash-flow)–but the forward P/E isn’t the only metric that is flashing a red flag on market valuation.
The Valuentum Buying Index, our stock-selection methodology, is also unfavorably distributed at present, with many more companies in our coverage universe garnering lower ratings (below 4) than higher ones (above 7). Though we are a little bashful when we pat our members on the back, the recent correction is a huge re-affirmation of the effectiveness of the Valuentum Buying Index as a stock-selection system. The Valuentum Buying Index not only considers individual equity fundamentals via a discounted cash-flow process and relative valuation comparisons, but it also embraces the collective behavioral tendencies of market participants via technical and momentum indicators. There are far more firms with lower ratings (1 through 4 = poor) than firms with higher ratings (7 through 10 = good). Here’s the Valuentum Buying Index distribution, as of February 5, 2014.
Image Source: Valuentum
Technicals
Though fundamental and valuation-based investors generally turn off at this point in the discussion, hang in there for just a minute. Looking at the broader equity performance of the S&P 500 during the past several years is an extremely valuable exercise, especially as it relates to gaining perspective. We cannot deny the behavioral and human tendencies that reveal themselves in the market each and every day, and the self-fulfilling trend lines that are carved out by technical traders are undeniable. For the sake of gaining perspective, let’s see how far we’ve come off the March 2009 lows and offer a plausible level that pure technicians are looking at. The technical work below points to a price correction on the S&P 500 to about 1670 by the end of 2014, a level that’s almost identical to the one supported by the valuation analysis. The stars seem to be aligned that market weakness remains ahead of us.
Valuentum’s Take
Investors should be cognizant that the recent pullback from all-time highs has been minimal in the context of the broader equity market performance in recent years (see image immediately above). A fundamental, valuation-driven analysis suggests the S&P could correct to 1670, and a technical-driven analysis indicates a return to a similar level. Coincidence? Perhaps. But when most investors are expecting the same thing in the stock market, the stock market is usually quick to reflect the collective view of its participants (the Valuentum framework). The S&P 500 is trading at roughly 1750 at present, and we wouldn’t think anything of a correction of another 5%.
That said, we’re not rushing to add put options on the S&P 500 (SPY) to the Best Ideas portfolio, as we’ve been burnt a few times in the past due to eroding time value (and we’re not advocates of short-selling by individual investors and financial advisors). Please note, however, that we’re currently evaluating a product that embeds short-selling in the Valuentum process (as opposed to put-options), per our academic white paper (click here), and we hope to have that rolled out shortly.
We’ve taken some lumps in the portfolio recently with Apple (AAPL), Buffalo Wild Wings (BWLD) and Ford (F), but we’re quite comfortable holding a 25% cash position in anticipation of scooping up shares of portfolio constituents once selling pressure lessens, or should the correction turn into an over-correction (a fall in the S&P 500 below the previous all-time highs of 1,560). We’re paying close attention to the markets, but you should not be surprised if a continued slide in equity prices is in the cards. We maintain our view that we’re well-positioned for continued relative outperformance.