Market Valuation July 2014

Some interesting commentary out this weekend on broad market valuation. I thought I would highlight each one, then briefly run through a quick valuation exercise myself.

John Hussman. Week after week Hussman continues to pound the table on how dangerous the market level is, yet Mr. Market refuses to cooperate. In this week’s note, he indicates that current valuation levels are approximately 210% above the historic norm. Given that the S&P 500 closed at 1255.19 the close before his “Hard Negative” note on 12.12.2011 where he proverbially “waved his arms” about the near- to medium-term risks facing investors, it is difficult to act on his concerns with the following tailwinds at investors’ backs:

  1. Younger-Than-Realized Business Cycle. According to the St. Louis Fed, 1Q14 GDP of $17 trillion was 94.9% of potential GDP. Based on my rudimentary look at this ratio going back to 1949, it appears the business cycle does not top out until we start operating above capacity. At current levels, we are still below the 97.43% low-point of the previous business cycle!! Unless the Fed becomes ultra aggressive with its rate hike program, or we get a large exogenous shock, I’d say we are at the mid-way point of this business cycle.
  2. Strong “Tape”. Slice it any way you want, but we are in a rip-roaring, “lower left to upper right” bull market, in which dips are being bought with ferocity. This is confirmed by the SPX’s 200dma being over 15% higher than it was 200 days ago.
  3. Easy Money. While one could make the argument that “tapering” is a tightening move, I don’t think this is backed up by hard evidence. High yield spreads, while aided by a lower denominator, are higher than the previous business cycle low. No indicator is perfect, but spreads began rising well before the market and economy peaked in the last business cycle.

Cullen Roche. Roche discussed the limits of using valuation metrics as timing tools here, and states the following toward the end of the piece:

“I’ve spent a good deal of time over the last 10 years trying to put “value” metrics to work.  I even cite them here on occasion just for perspective.  But I have found it nearly impossible to apply these metrics in any useful sense.  And if the last 20 years tell us anything it’s clear that many of these valuation metrics are junk and relying on them will lead you astray.”

I find it interesting that Roche criticizes Smithers for missing the market move since 2009, but cites “the last 10 years” as personal evidence of valuation metrics NOT working. In my opinion, the last 10 years are fantastic evidence!! The S&P 500 closed at 1093.88 on 7.21.2004 – at its nadir in March 2009, the market had fallen ~39% from this level despite first climbing ~37% to over 1500. While one should not base 100% of their asset allocation decisions on the expected return for the S&P 500, for long-term savings allocation, valuation metrics matter enormously.

Jeremy Grantham. Out of the three presented here, I believe Grantham is the most balanced. He is for sure a long-term bear, but he believes that the business cycle remains relatively young, and that the M&A cycle has only begun to pick up. With returns on capital high and the cost of that capital low, corporate managers have huge medium-term incentive to buy growth. He sees the market climbing to at least 2250 on the S&P 500, if not a good bit beyond.

Market Valuation. There are hundreds of ways to slice and dice market valuation, 99% of which I will not go through here. The following is just a simple analysis of book value and reported earnings for the S&P 500.

  • FYE 2006: SPX BVPS $504.39, LTM EPS $82.06.
  • FYE 2013: SPX BVPS $635.56, LTM EPS $100.42.
  • ROE: From 2007 to 2013, retained earnings were $131.17 per share and reported earnings grew $18.36 per share (2006 to 2013), which translates into an estimated ROE of 14%. For reference, reported ROE averaged 13.6% from 2007-2013 with 2008 excluded.
  • Growth Rate: EPS grew 2.9% per annum from 2006 to 2013.

Because the 2006-2013 ROE (14%) and the 2013 reported ROE (15.4%) are right in line with historic norms, for the sake of argument I am going to assume 2013 EPS of $100.42 represents normalized mid-cycle EPS. For the next ten years, I assume an average ROE of 15% and earnings growth of 5%. Due to the extremely low interest rate environment, my scenario analysis looks at three different discount rates. S&P 500 fair value looks as follows using the above-stated assumptions and three different discount rates:

  • FV @ 8% Cost of Equity: 2343
  • FV @ 9% Cost of Equity: 1757
  • FV @ 10% Cost of Equity: 1406

Alternatively, were future cash flows to be discounted back at 8% but the terminal value be based on a 10% cost of equity, the fair value would be 1636.

While it is easy to get sucked into honing in on a single-point fair value estimates provided by the likes of Hussman, Grantham and Smithers, I believe a “zone of fair value” methodology, such as the one Buffett has cited throughout his career, is more applicable to the intelligent investor. With the business cycle relatively young, market gauges showing little sign of long-term exhaustion, an extremely easy monetary environment, and healthy skepticism toward the market advance, it appears imprudent to quibble about market valuation while it remains within a reasonable “zone of fair value”.


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