$$ Market Valuation Thoughts
- Posted by ToddSullivan
- on October 18th, 2010
Don’t usually comment on the market in general but since so many people are asking, rather than reply to emails, I’ll address it here. This market is NOT overvalued.
Below is the most recent S&P earnings data (as of 10/13). Couple of comments. Even after this rally, the S&P at its current levels, is the 2nd cheapest on both reported and operating earnings as it has been this decade (this past June was the cheapest ). Far too often market commentary is focused on the “% move in the market” without the added emphasis on what the underlying fundamentals are doing. We also see a myopic focus on what the macro picture may or may not be and then immediately extrapolate that to the market. The thesis seems to be “the market has moved X percent and overall economic growth seems to be slow, therefore the market is due to pull back”
What this line of thinking ignores is the fundamentals supporting the market’s price. YOY S&P earnings to date are up 24% while the market is up 5%. That 24%, from what we have seen so far looks set to rise more as additional earnings come out this week. When you look at earnings results and the current market price, 1177 on the S%P is more than reasonable. What we have now is dramatically rising earnings YOY and an essentially flat market which compresses the PE.
The macro bears will say that we are going to slow down. We have to ignore the perma bears in this conversation because listening to them since March of ’09 would have been utterly disastrous to your portfolio. They will always be negative. While they provide value in that they will present the “devils advocate” argument in every situation, theirs is more an academic discussion rather than an actionable one. I think we can take the double dip scenario off the table at least until the end of 2011 (regular readers know we do not engage in > one year predictions here) barring a systemic shock (tax cuts not extended, terrorist attack, large natural disaster etc.). What the bears want us to believe is that slowing growth will cause the market to collapse/dramatically retreat/insert melodramatic phrasing here. Well, that is completely true, if the S&P is trading at 20-25 times earnings. At 12 times 2011 earnings, it doesn’t. Think about those numbers, at 25 times earnings the S&P would be sitting in excess of 2000 vs today’s 1177. That is a bit of a spread…no? The key is the word growth. Do you know what a GDP of 1% or 4% have in common? Both numbers mean the economy is growing.
Even if GDP comes in at 1% (I believe it will be higher) the economy is growing and profits will also. When you have a market trading at 12X operating earnings for 2011 you do have margin of safety. We can also say that at that level, the market is fully anticipating growth slowing. As long as it only slows as expected and does not contract, earnings will still grow and the value of the market will grow along with them. We now have to look at the other scenario. What if it doesn’t slow as expected? What if GDP continues at the 2%-2.5% rate rather than the sub 2% most people expect? Well, then you have a market a very cheap market that is going to see S&P earnings growth continue to grow at a healthy rate.
Also bullish, S&P companies added $5.1B to dividend payments in Q3. Those payments are stimulative for the overall economy. With the consumer such a large part of the economic picture, increased dividends are stimulating to the economy. This of course assumes we do not raise that tax on them (current plans are ambiguous). If Congress wants corporate America to part with its cash, maybe actually lowering that tax rate would provide more stimulating? Yes, I know most dividends go to mutual funds but most of that is then paid to fund holders and even those who chose to reinvest them see a benefit.
Am I saying the market is grossly undervalued? No. I would say it is fair to slightly undervalued as of today for results to date (not looking forward). Am I calling for a huge rally? No. I am saying the market is leaning towards the bear case (not sure there is any other conclusion at 12X forward operating earnings). Basically you could say the market thinks they are more right than wrong. If it turns out they are more wrong that right, that leaves room for significant upside. For a large rally going forward, earnings and the overall economy will have to prove the bears in error.
Eventually price and value always meet, always. We have a market pricing in decreasing value. I think it is wrong…..
Now the bears will say the market is overvalued. They will say that the S&P based on inflation adjusted earnings or the S&P priced in gold, bat guano or stuff stuck to the bottom of my shoe is by all historical measures, expensive. Here is my problem with that. Doing it that way means we now have to have a conversation on the true inflation rate (the gov’t has changed its calculation), is gold in a bubble, how much protein is in that bat guano and just what is that stuck to my shoe?. Nobody priced the S&P in terms of gold until it took off, once it recedes, no one will then either. In other words, we now have more confusion, not less. We have to not only worry about the quality of earnings but the quality of other, more unreliable inputs.
More ambiguous data points produce a less dependable end result. One can find a measure to back whatever thesis one want’s to project. One can find a statistic to say anything one wants and yes, I do think the Roubini’s and Rosenberg’s out there consciously ignore data that counters their desired thesis. I also think that as right as they were in 2008, they have been more wrong since and do not deserved the reverence placed on them by the MSM (as more people look at Roubini’s past predictions, it seems 2008 may have been the ONLY time he was right). Because of that, I like to stick with the most basic, the ones least easily manipulated. Until I hear Apple or Exxon reporting earnings in terms of gold or inflation adjusted terms, we’ll just stick with the good ‘ole fashioned way and go by what they actually earned.
With all that, here is the data:
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Todd's investing strategy is essentially long with the rare short. He seeks to buy undervalued issues with an upcoming catalyst that will help them realized.... More »
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