Question for U.S. Stock Bulls Is When Valuations Start to Matter

  • Citigroup strategist called stocks `screamingly attractive'
  • Wednesday's 3.9% rally started from lowest P/E since 2014

Four months ago, Janet Yellen pronounced U.S. equity-market valuations “quite high.” Now Citigroup Inc. and Stifel Nicolaus & Co. say they could have the power to stanch the bleeding in American equities.

They were “screamingly attractive” to Tobias Levkovich, Citigroup’s chief U.S. equity strategist, when he spoke on Bloomberg Radio just before the Standard & Poor’s 500 Index staged its biggest rally in four years. Chad Morganlander, a money manager at Stifel Nicolaus in Florham Park, New Jersey, said that they had fallen almost enough for investors to feel safe buying.

Prior to Wednesday’s rebound, the selloff that wiped out $2 trillion in market value brought the price-earnings ratio on the Standard & Poor’s 500 Index down 11 percent to 16.5. Whether that had anything to do with the rally may depend on how you view history. As recently as May, Federal Reserve Chair Yellen said shares were the opposite of cheap.

“There are dozens of ways to torture the numbers to make any number of cases regarding valuations,” Morganlander, whose firm oversees about $170 billion, said by phone. “Eventually the reality that valuations have come off so much will come into play.”

At the center of one of the biggest bull cases on U.S. equities is an assessment incorporating bonds that is sometimes referred to as the Fed Model. The theory is that cash flows from fixed-income investments can be compared with profits generated by companies to arrive at a relative value for each.

Using that, American stocks have been inexpensive relative to Treasuries for the duration of the bull market -- and remain so now. The S&P 500’s earnings yield, calculated as its overall earnings divided by price, is about 5.8 percent. That’s 3.65 percentage points more than the 10-year note pays out, compared with an average difference of 0.32 point in 53 years of data compiled by Bloomberg.

Yellen noted the bonds comparison when she spoke at a forum on finance in Washington on May 6.

“I would highlight that equity-market valuations at this point generally are quite high,” Yellen said in response to a question. “Now, they’re not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low. But there are potential dangers there.”

High or not, valuations have seldom put a brake on the bull market before 2015. The S&P 500 rose almost 30 percent in 2013, a year in which its price-earnings ratio got as high as 17.9, more than a point above the average over the last 10 years. It climbed another 11 percent in 2014 when the ratio averaged 17.7.

At Tuesday’s close, the market multiple of 16.5 was the lowest since February 2014.

Based on Levkovich’s models at the start of Wednesday, the markets were “sitting at one-to-two standard deviations below the weekly average going back to 1971,” he said, implying a “96 percent probability of markets being higher a year from now.” He cautioned that fundamentals need to support a price recovery, particularly in industries such as raw materials and energy, which are at multi-year low valuations.

‘Near Value’

The entire S&P 500 has a lot more to decline should the market play out according to past bottoms. When the index hit a 12-year low in March 2009, it was trading at 11 times annual profit. In October 2011, at a 13-month low, the S&P 500’s price-earnings ratio was 12.3.

“We’re not in the camp that valuations are screaming buy at these levels,” said Tom Manning, chief investment officer from Boston Private Wealth, which oversees about $9 billion in assets. “Valuations are likely to go higher but that is not to say they are exceedingly cheap, or cheap for that matter. They’re somewhere near value.”

An obsession with historical comparisons seems misguided to Laszlo Birinyi, the investor whose bullish calls have repeatedly come true since 2009. Sentiment is as likely to drive prices as anything else, the 72-year-old former Salomon Brothers Inc. analyst wrote in an Aug. 5 note to clients.

He cited the cyclically adjusted price-earnings ratio championed by Robert Shiller, which compares index levels to 10 years of earnings instead of just one. Going by its signals since 1926, Birinyi wrote, the S&P 500 should have returned less than 1 percent a year in the decade after the dot-com bust. It returned almost five times as much.

“Our bottom line is that many market metrics and indicators are based on a
cyclical environment which no longer exists,” he wrote.

One lesson from history does hold for when the market eventually rebounds.
“Those that get nervous here and move to the sidelines are going to lose
twice, on the way down and then because they weren’t able to participate in the bounce,” Jonathan Golub, chief strategist at RBC Capital Markets LLC, said in an interview on Bloomberg Television. “Those things that you probably liked before you should like now at cheaper prices.”