Big gains, low valuation ahead on Wall Street

  • Business
  • Monday, 18 Mar 2013

NEW YORK: Major stock indexes have never been higher and yet that's hardly scaring people.

Stocks have soared in 2013, with the Dow climbing almost 11% to hit a series of new all-time highs while the S&P 500 has jumped 9.4%, falling just short of its all-time closing high after rising for 10 of the past 11 weeks. And yet, analysts for the most part see equities as fairly cheap.

The rally has slowed, however. In the last eight trading sessions, the S&P 500 has managed a daily gain of more than 0.5% just once. Questions remain about the potential impact of US budget negotiations or the Federal Reserve's plans in continuing its massive monetary stimulus. The Fed meets next week.

Taken on its own, analysts see potential for more gains in the US stock market, based on metrics like earnings prospects and valuation. The forward 12-month price-to-earnings ratio for the S&P 500 is currently 13.5, which is about 9% less than the October 2007 ratio of 14.8 when the S&P last hit a record.

“This shows that stocks are cheaper than they were at the time of the last high, and at the same time, alternative assets like bonds are much more expensive,” said Paul Zemsky, head of asset allocation at ING Investment Management in New York, who helps oversee US$170bil.

“We are at record levels, but you need to look at stocks in the right context, and in that context, they're not expensive at all.”

The S&P 500's earnings yield a reverse of the price/earnings (P/E) ratio currently stands at 7.1%, compared with 6.41% for the Bank of America Merrill Lynch US High Yield Index.

That's an anomaly in the markets the earnings yield has generally been lower than a benchmark junk-bond yield because it measures the risk of owning the highest-quality stocks versus the expected return on the lowest-quality bonds.

The current P/E ratio is also below the historic average of 14.8, according to Thomson Reuters data dating back to 1968. The S&P 500 would need to rise to about 1,647 to become in line with the historic average about 5.6% above current levels, according to Standard & Poor's.

Interest rates remain near record lows while dividends are growing, another way that stocks are outshining bonds.

In the most recent quarter, the average dividend yield for S&P 500 companies was 2.19%, more than the 1.89% yield in the fourth quarter of 2007, the period of the last market peak, according to Standard & Poor's. In 2012, 403 S&P 500 components paid a dividend, the highest number since 1998.

In contrast, the 10-year US Treasury note currently yields 2%, so the dividend yield on the S&P 500 would pay more than the bond, without even factoring in potential price growth.

The S&P 500 is also trading well below its intrinsic value, another metric of earnings-based valuation that estimates where a security should trade, based on its expected growth trajectory over the next decade or more.

The index is seen as having a price-to-intrinsic value ratio of 0.85, according to Thomson Reuters StarMine, which means it would have to rise 15% to be in line with its earnings growth trajectory. More than two-thirds of companies are below their intrinsic value, including some of the biggest.

Apple Inc, which has tumbled 16.6% this year, is 28.2% under its intrinsic value, based on its Friday closing price, while Exxon Mobil Corp is 23.3% under and Bank of America Corp is 53.3% under its intrinsic value.

Other companies show signs of being overbought. Google Inc, which has jumped about 15% so far this year, is about 16% higher than intrinsic valuation. Inc is 85% above its intrinsic valuation of US$39.17.

“You need to be selective. While on the whole, we're in a constructive market supported by dividends and earnings, some companies have probably seen peak levels already,” said John Carey, portfolio manager at Pioneer Investment Management in Boston, which has about US$200bil in assets.

The market's gains this year have come on accommodative monetary policy from the Federal Reserve and strong corporate results, two factors that investors don't see going away any time soon.

The Fed's interest-rate-setting committee meets next week. Despite calls from some of the board's more hawkish members to reduce asset purchases, the Fed is expected to continue on its current path.

Recent data ranging from retail sales and manufacturing to employment has shown the economy is picking up some momentum. But the high US unemployment rate of 7.7% gives the policy committee room to keep buying US$85bil a month in bonds to keep interest rates low.

And while the stock market's two previous peaks were followed by recessions stemming from the bursting of the dot-com bubble in 2000 and the 2008 credit crisis, there is no apparent equivalent today. - Reuters

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