Monday, June 9, 2014

S&P 500 Nearing 2014 Target Ahead of Schedule (excerpt)

The S&P 500 closed at 1949.44 on Friday. It would have to rise by only 3.3% to reach my yearend target of 2014. What if it hits my yearend target within the next few days or weeks? Somehow, 2015 by 2015 doesn’t seem like a very compelling forecast. In fact, 2014 by the end of 2014 might still play out, but there could be a melt-up between now and then. I was hoping that the internal correction over the past two months would reduce the likelihood of an irrational exuberance scenario for the market. Now I am not so sure. Consider the following valuation metrics showing that stocks aren’t cheap:

(1) P/E and price-to-sales ratio. On Friday, the forward P/E rebounded back up to 15.5 from a recent low of 14.4 on February 3. That’s a new high for the bull market, and the highest since June 20, 2005. I also track the ratio of the S&P 500 stock price index to its forward revenues. It rose to 1.63 at the end of May, exceeding the previous cyclical peak of 1.56 during the week of July 19, 2007.

The ratio of the S&P 500’s market capitalization to its actual revenues rose to 1.64 during Q1, the highest since Q1-2002. The ratio of the market value of all domestic equities traded in the US to nominal GDP rose to 1.63 during Q1, the highest since Q3-2000.

(2) GDP P/Es. The ratio of the value of all US stocks traded in the US excluding foreign issues to after-tax profits from current production rose to 13.8 during Q1, the highest since Q4-2007.

(3) Tobin’s Q. Many years ago, Professor James Tobin of Yale (and the chairman of my PhD committee) devised his Q Ratio, which is the total market value of a firm divided by the replacement cost of building the firm from scratch. When Q exceeds 1.00, entrepreneurs have an incentive to build it because its market value will exceed its cost.

That’s obviously a very theoretical construct used to explain the capital spending cycle. Nevertheless, the Fed’s Flow of Funds database includes two series that can be used to derive a Q ratio for the overall market showing the extent to which investors are either overvaluing or undervaluing the capital stock. I adjust it so that it has equaled 1.00 on average since the start of the data in 1952. During Q1, it rose to 1.56, the highest since Q4-2000.

(4) Bear case. Any way we slice and dice it, stocks aren’t cheap. At best, they are fairly valued. Of course, the bears say that they are grossly overvalued because they are expecting a recession. In their opinion, the problem is that earnings are at a record high and so are profit margins. So these two are increasingly likely to go down rather than up.

According to the bears, P/Es based on forward earnings are underestimating the overvaluation problem because they are based on analysts’ consensus expectations for earnings that are too optimistic. That’s true if a recession is coming soon. I don’t see one coming soon, so I don’t have a problem using forward P/Es for assessing valuation. Nevertheless, there is a valuation problem, though it isn’t as extreme as the bears say it is. Of course, a melt-up would force me to reassess my position.

Today's Morning Briefing: Lake Winnipesaukee. (1) Fewer bears at Bahre’s annual retreat. (2) When will the Fed start hiking rates? (3) Will termination of QE trigger a stock selloff? (4) Bubbles everywhere? (5) 2015 by 2015? (6) What’s next: a melt-up? (7) Various valuation ratios all show stocks aren’t cheap. (8) Unemployment rate at 5.5% by January. (9) Low wage inflation should moderate Fed’s rate hikes once they start. (10) YRI Earned Income Proxy at record high again. (11) Fewer amber lights on Yellen’s dashboard. (More for subscribers.)

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