An Eye on Valuation

US equities piled on another month of gains in February. So far this year, the indexes in the US stand on higher ground. Specifically, the index level of the S&P 500 was about 11% above last year’s close when February ended. Anyone who sold-out of the market late last year and went for the sidelines may be feeling some type of remorse in this period of rising stock valuations. In their defense, however, there are still plenty of unknowns out there.

What’s been especially vital this year are the technical internals in the equity indexes. For one, the percentage of equities listed in the S&P 500 that now trade at prices above their 200-day moving averages has surged nearly 60-fold in the first two months of this year. Additionally, the S&P 500 is sitting above its own 200-day moving average. The index’s cross above is surely a sigh of relief for bullish sentiment. Still, the index resides below last year’s highs, which is undoubtably what the bears will cling to.

In opposition to rising stock indexes is a steadily declining trend of volatility or uncertainty in equity prices. Heuristically speaking, excessive uncertainty creates buying opportunities and lesser uncertainty is preferred in a holding environment for equities. The VIX is the preferred index for gauging uncertainty in equity prices. The VIX is simply the implied uncertainty that is priced into the S&P 500’s derivative contracts (options). In February, the VIX was practically cut in half from where it was in last December. In hindsight, December was an excellent entry point into stocks.

A gaze into the internals of the S&P 500’s fundamentals also offer some points of interest. The index has produced respective quarterly growth rates over last year’s quarter for earnings and revenues of 13.1% and 5.8%. This is the fifth consecutive quarter where earnings have grown in the double-digits!

But forecasts indicate that previous growth rates are about to slow down. In fact, the analysts on Wall Street are projecting that this year’s full growth rate for earnings will be 4.1% on revenue gains of about 5.1%. Earnings growth that is below revenue growth is not exactly the reality that investors like to live in.

What’s more, stock indexes are gaining in a period when estimates of earnings are being cut. This means stocks are becoming more expensive in relation to their forward earnings. A simplified interpretation suggests that stocks have become dearer to investors.

The forward earnings estimate can also be used to value the S&P 500. Today, the index is believed to trade around 16 times forward earnings. Investors will cite that the average valuation for forward earnings is closer to 15 times. Sure, today’s valuation isn’t outside the realm of reasonability. However, any further weakness in earnings would make stocks even more expensive today.

More optimism: the S&P 500 looks undervalued based on the Wall Street’s price estimates for individual securities.

The analysts on Wall Street set target prices for the companies that they cover. A bottom up approach that sums those target prices indicates that the index level could reach $3,062, which is a 10% premium above today’s level!

Truly, value is in the eyes of the holder. Every investor has their own thoughts of what value is at various points in time, which is why equities can move from one excess to another. The not so secret truth about successful investment strategies depends a lot on a person’s ability and willingness to be patient and disciplined. That’s what makes equity investing so hard. Are you likely to sell at depressed prices when fear overcomes markets? Or, are you prepared to rebalance and sell high when others are being greedy?

Advisory Alpha