Buying Low Thwarted by Narrowest Stock Valuation Gap EverWhitney Kisling and Nick Taborek
Cheap is converging with expensive in the American equity market, narrowing options for investors looking for bargains after the broadest rally on record lifted almost 90 percent of the Standard & Poor’s 500 Index this year.
The difference in valuations shrank to the smallest since at least 1990 after companies from Hormel Foods Corp. to CenterPoint Energy Inc. rose to levels that match those with twice the profit growth, such as Ralph Lauren Corp. and Citrix Systems Inc. A measure of the dispersion of price-earnings ratios in the S&P 500 compiled by Goldman Sachs Group Inc. narrowed to 41 percent in June, the lowest on record, and held around that level since.
While four years of earnings growth and the Federal Reserve’s near-zero interest rate have led the S&P 500 on a 166 percent rally since March 2009, they have also driven up valuations just as the bull market approaches the end of its fifth year. The monolithic market means investors may have nowhere to hide should shares fall.
“We’ve seen a runup in prices in the market, and we don’t think it’s cheap anymore,” Bruce McCain, who helps oversee more than $20 billion as chief investment strategist at the private-banking unit of KeyCorp in Cleveland, said in a Nov. 13 phone interview. “Those who simply like to buy cheap and get a regression to the mean may have less luck.”
The S&P 500 climbed 1.6 percent to a record 1,798.18 last week after Fed Chairman-nominee Janet Yellen signaled she will continue the stimulus programs of her predecessor Ben S. Bernanke, and retailers suggested holiday demand would be stronger. The measure advanced 26 percent in 2013, on track for the biggest annual return in a decade. The S&P 500 fell 0.4 percent to 1,791.53 at 4 p.m. New York time.
More than 440 of the S&P 500’s companies have gained in 2013, the most for any year at this point since at least 1990, data compiled by Bloomberg show. Advances since March 2009 have been spread among all 10 S&P 500 groups, with consumer discretionary shares up 309 percent, about four times the jump in shares of utilities companies. In the bull market from 2002 to 2007, energy stocks outpaced consumer staples shares by about sixfold.
The breadth of this year’s rally has led valuations throughout the market higher. The average S&P 500 company’s price-earnings ratio rose 40 percent to 20 in 2013, twice the increase for 2012 at this point of the year, according to data compiled by Bloomberg.
“This market clearly has had a life of its own that’s been divorced from a lot of economic reality, and so valuations are much higher,” Martin Leclerc, founder of Barrack Yard Advisors LLC, said in a Nov. 14 phone interview from Bryn Mawr, Pennsylvania. His firm oversees $230 million. “Everyone bemoans the fact that the set of companies selling at very good prices has really been diminished.”
Health-care shares saw the biggest multiple expansion this year, trading at 17.5 times estimated earnings last week, the highest since 2007. A group of consumer-staples stocks trades at 18.6 times estimated earnings, compared with the average of 16.4 before the bull market, according to data since 1990 compiled by Bloomberg. The price-earnings ratio for utilities shares reached 16.1, compared with the 13.8 average before 2009.
“The mantra was bond-like stocks for 18 months, from the middle of 2011 until Bernanke said the word taper,” Eric Green, director of research and fund manager at Penn Capital Management, said by phone Nov. 14. The Philadelphia-based firm oversees about $7 billion. “The uncertainty has forced individual investors and institutions into more defensive types of stocks.”
Hormel Foods’s valuation climbed 33 percent to 20.3 times estimated earnings in the last 12 months. The multiple for the maker of Spam luncheon meat is 30 percent higher than the mean for the decade before the bull market, according to data on reported earnings compiled by Bloomberg.
CenterPoint Energy, which distributes power to Houston, is up 30 percent in 2013, boosting the price-earnings ratio to 17.2 from 14.1 in January. Before this year the utility provider traded at a 33 percent average discount to the S&P 500 since 1990, data compiled by Bloomberg show.
Shares of AmerisourceBergen Corp., the pharmaceutical company that pays a 24-cent dividend, advanced 61 percent this year. The price-earnings ratio for the Valley Forge, Pennsylvania-based company increased 53 percent to 18.9 in 2013, Bloomberg data show.
Those valuations are about the same as stocks with earnings more tied to economic growth. Ralph Lauren, the retailer of its namesake brand clothing, trades at 19.1 times profit projections. Citrix Systems, the Fort Lauderdale, Florida-based software maker, has a multiple of 17.6, and Monsanto Co., the world’s largest seed company, trades at 21.1 times earnings. ˜
“Investors are assigning similar values to more stocks despite very different earnings growth profiles,” Brian Belski, chief investment strategist with BMO Capital Markets, wrote in a note last month. “These trends are not likely to continue.”
The longer a rally goes on, the more valuations adjust to individual companies’ earnings, meaning stocks with lower growth whose multiples have surged this year may see them drop back down, according to Belski.
While stock prices have risen faster than S&P 500 profits, analysts expect earnings to pick up in 2014. Profits will expand 10 percent next year and 11 percent in 2015, according to Bloomberg data. Nine of 10 S&P 500 industries will post faster individual growth next year, analyst estimates compiled by Bloomberg show.
“The P/E is just a reflection of expectations of how much those cash flows are going to grow,” Wayne Lin, a portfolio manager at Baltimore-based Legg Mason Inc., which oversees $670 billion, said in a Nov. 13 phone interview. “Earnings can continue to grow,” he said. “This runup is just a return to fair value for equities.”
Shares of companies whose earnings depend on economic growth are still cheaper than historic averages. A group of technology stocks has a valuation of 14.6, 27 percent lower than the average since 1991 and a fraction of the level it reached in 2000, data compiled by Bloomberg show. Energy shares are 9.1 percent cheaper than the 22-year average.
The full S&P 500 trades at about 17.5 times trailing 12-month earnings, in line with the average since the end of World War II, according to S&P data. The multiple stayed low as profits almost doubled from the level in 2008 and the Fed’s accommodative policies kept stocks relatively attractive.
“With interest rates at current levels, the market is not expensive,” Donald Selkin, who helps manage about $3 billion as the New York-based chief market strategist at National Securities Corp., said in a Nov. 14 phone interview. “The market has room to go higher.”
Stocks have jumped as the Fed held its benchmark lending rate near zero since December 2008 and bought more than $2.3 trillion in Treasuries through unprecedented quantitative easing programs. Economists say the Fed will lower the $85 billion in monthly purchases to $70 billion in March, according to the median in a Bloomberg News survey conducted Nov. 8.
“What everybody’s been trying to figure out this year is how much longer is the Fed going to keep us on life support and if they do taper, are we going to continue to see the growth we’ve enjoyed the past couple of years?” Thomas Garcia, head of equity trading at Santa Fe, New Mexico-based Thornburg Investment Management Inc., said in a Nov. 14 phone interview. His firm manages more than $90 billion. “That’s the big question.”
The last time the dispersion of valuations came close to being this narrow was in October 2006, a year before the last bull market ended, Goldman Sachs data show. Before that, multiples were most compressed in September 1997, 10 months before the biggest bull market on record ended.
Goldman Sachs’s price-earnings ratio dispersion is a monthly reading of standard deviation, or the variance from the average, for companies in the S&P 500. Goldman Sachs compiles data for companies whose price-estimated earnings ratios are between zero and 75.
Bull markets since World War II have ended after about four years, according to the average of data compiled by Bloomberg and Birinyi Associates Inc. This rally has lasted more than 4 1/2 years. Its 166 percent gain has exceeded the 122 percent average return for the last 12 bull markets.
“We’ve gone from the fear of losing to the fear of losing out,” Leclerc said. “That’s always a dangerous inflection point.”