The Dow Jones industrial average climbed over 17000 recently before dropping to just above 16,000. The S&P 500 a brother measure of stock performance in the US is expected to hit the much anticipated 2000 points anytime soon. Americans investors are wondering of this is another bubble in the making or if the market is just a reflection of an economic rebound. Americans question their successes and failures and will always resort to historical trends to predict the future. This is how they do it… just patiently read this Reuters article.
The S&P 500 is closing in on the vaunted 2,000 mark, but a growing number of strategists, looking at common measures of valuation, are wondering if it is justified.
By some measures, like the oft cited forward price-to-earnings ratio, stocks are modestly expensive. But others – such as a long-term adjusted P/E ratio – suggest stocks have run far ahead of themselves. That doesn’t necessarily mean stocks are headed for a correction soon. Wall Street defines a correction as a drop of 10 percent from a recent peak.
“There are periods, for instance in 1999, when you would say markets are expensive, and they got more expensive before they blew up. So anybody who sat there saying, ‘I am going to short the market because it is really expensive’ lost their shirts,” said Tobias Levkovich, chief U.S. equity strategist at Citigroup in New York.
The Standard & Poor’s 500 Index .SPX set records consistently in recent weeks, but the moves were slow as more investors worried about stocks being overvalued.
In research notes on Tuesday, strategists at Morgan Stanley and Bank of America-Merrill Lynch both suggested that stocks are no longer inexpensive. Morgan Stanley strategist Adam Parker wrote that “we do think the risk-reward is more balanced than bullish for the S&P 500 in the second half of 2014.”
A LOOK AT HISTORIC RATIOS
According to Thomson Reuters Datastream, the forward price-to-earnings ratio of the S&P 500 stands at 15.68, slightly above its historical average of 14.89, but not necessarily screaming “expensive.”
A slightly different measure, forward operating earnings, suggests stocks are pricier than their historic norm. As of June 30, operating S&P 500 earnings for 2014 are expected at $119.60, for a forward operating P/E ratio of 16.42. The 2015 estimate of $137.52 puts a 14.25 forward operating P/E ratio on the S&P 500.
Operating earnings measure a company’s profit after removing costs normally associated with running the business.
Both of those measurements would indicate equities are not yet overly expensive, with the caveat that they are based on estimates, which are subject to change.
However, according to Datastream, the last time the forward P/E ratio approached this level was in May 2007, five months ahead of the market’s peak before the financial crisis of 2008. The forward P/E ratio was also more expensive in November 1996, but the bull market raced along until the dot-com bubble burst in March 2000.
“If you look at it the way many institutional investors look at it, which is on forward (operating) earnings, institutional investors don’t get super-nervous until you get to 18,” said Nicholas Colas, chief market strategist at the ConvergEx Group in New York.
ON THE CAPE
One measurement that has garnered a fair amount of attention is the Shiller P/E ratio, or cyclically adjusted P/E (CAPE) ratio. Created by Yale economics professor Robert Shiller, it derives a price-to-earnings ratio based on average inflation-adjusted earnings for the previous 10 years, in an attempt to smooth out anomalies in earnings figures.
The CAPE ratio stands at 26.25, far above its 16.54 historic average. It’s just shy of the CAPE ratio of 27.31 seen at the October 2007 peak – about 11 months before the market crashed. But such lofty levels for this measure in 1996 did not stop the rally from running along for a few more years.
More recently, the 2008 crash resulted in the S&P 500’s only negative earnings figure in its history, which skews the P/E ratio in that period of time, and makes some strategists skeptical of the current CAPE figure.
“I don’t buy the Shiller Adjusted P/E,” said Jeffrey Saut, chief investment strategist at Raymond James Financial in St. Petersburg, Florida. “It had a pretty good track record but on a 10-year look back, you have to assume what we saw in 2008 and 2009 is typical.”
USING YIELD AS A YARDSTICK
Meanwhile, the big bond rally over the last several years makes stocks look attractive in some ways, when comparing the earnings yield to the 10-year U.S. Treasury note. The earnings yield takes the earnings per share of the latest 12-month period and divides it by the S&P 500’s current level.
That yield for the S&P 500 currently stands at about 6.4 percent. That’s 3.8 percentage points higher than the 10-year Treasury note’s yield, currently about 2.60 percent. The median gap between stock and bond yields over the past 30 years is about 1.4 percentage points. That makes sense, as stocks are the riskier asset, but this difference suggests stocks remain a relative bargain to Treasuries.
As the Fed winds down its monetary stimulus and if the economy continues to improve, then long-term bond rates could rise. That could narrow that spread and prompt some reallocation.
There is a lot we can learn from here as Nigerians right?