- After a 10% gain in 1Q 13 (in USD terms), the S&P 500 closed the quarter at a new all-time-high
- While some may feel that the current price level of the S&P 500 suggests that it is time to cash out, we prefer to make the distinction between “price” and “value”
- Firstly, a comparison of the US market of 2007 and 2013 shows the disparity in “value”; US equities are more attractive now than in 2007 on various measures
- Moreover, investors should remember than earnings growth is a critical component of stock market returns, alongside dividend yield and PE re-valuation; over the past 66 years, S&P 500 earnings have risen 7.2% p.a., fairly close to the 7.1% gain for the S&P 500 (excluding dividends)
- It is more important to focus on the trend of earnings rather than price levels; it is on the basis of earnings growth that stock markets can make new highs and not be constrained by the highest index level achieved previously
- The recent rapid ascent of the US market also goes to show that stock markets can move quickly when investors least expect it
- Timing the market is a difficult art and we prefer to advocate a valuation-driven approach; our approach has incurred the wrath of investors in the past especially when markets have been turbulent, although our upgrade of the market in late-2011 (although unpopular at the time) has since been vindicated, as has been our upgrade of the US market in late 2008
- Economic indicators we track point to better growth ahead for the US economy, spurred by an improving housing market alongside better job market conditions
- We believe that a combination of economic tailwinds and attractive valuations will spur the market to further gains, with a forecasted return of nearly 13% annualised (including dividends) for the market by end-2015; we maintain a 3.5 star “attractive” rating on the market
Chart 1: US market at a new all-time high
S&P 500 at a new all-time high
The S&P 500 index recently ended 1Q 13 at a new all-time-high of 1569.19 points, finally surpassing the 1565.15 closing high achieved in 2007 (see Chart 1), and having risen a hefty 131.9% (in USD terms, excluding dividends) since the market trough in March 2009. Driven by a swift resolution of the “fiscal cliff” situation which threatened to derail the US economy alongside continual improvements in both the housing market and job market, investor sentiment improved in 2013, helping the S&P 500 post a 10% gain on a year-to-date basis (as of 28 March 2013), the third-best performing market under our coverage in 1Q 13.
Price versus Value
While some investors may feel that the current price level of the S&P 500 suggests that it is time to cash out, we prefer to make the distinction between “price” and “value”, as we have alluded to numerous times in the past (see Value, Prices & Volatility and Idea Of The Week: Benefiting From Price and Value Dislocations [19 Aug 2011]). To us, a high price of a stock market or a particular stock (or even the NAV of a fund) is certainly not indicative of the attractiveness of the investment; rather, it simply serves as a basis of comparison for historical investment returns. Rather than being overly-focused on the “price” of an investment, we prefer to focus on “value” – whether the US market remains an attractive investment opportunity at present levels.
2013 versus 2007
With the S&P 500 presently just 0.3% higher than its prior 2007 highs (such that the “price” of the US market is nearly identical today compared to back in October 2007), it is therefore instructive to look at some factors which can help determine the “value” of the market, namely earnings, net asset value and revenue.
Chart 2 shows the trend in S&P 500 earnings between 2001 and 2015 (forecasts in green), clearly indicating that earnings have posted substantial growth from 2007 levels. With an earnings-per-share of 103.53 in 2012 versus 84.63 in 2007, earnings of S&P 500 companies have grown a hefty 22.3% since the market last peaked, with consensus forecasts suggesting that 2013-2015 will see further growth in the measure. With earnings forming the “E” portion in the PE ratio (our preferred valuation measure), the US market currently trades at 15.2X historical 2012 earnings (14.2X based on estimated 2013 earnings), compared to the 18.5X valuation at the previous peak of the market in 2007. Simply put, the US market is currently over 22% cheaper now compared to during its 2007 highs.
Chart 2: S&P 500 Earnings
Net asset value
Chart 2 also shows that earnings can fluctuate during recessions (S&P 500 earnings saw a hefty dip in 2008 and 2009 over the prolonged US recession) so a look at “net asset value” or “book value” is also instructive for comparing market valuations in 2007 and 2013. Net asset value is a measure of a company’s assets minus its liabilities – the measure tends to fluctuate less compared to earnings and gives us a good indication of how much the S&P 500’s underlying companies are worth upon liquidation.
As shown in Chart 3, the net asset value of S&P 500 companies has risen over the years as companies become more valuable due to higher profitability and asset growth. Since 2007, the S&P 500’s net asset value has risen from 530.47 to 668.95 (as of end-March 2013), an increase of 26.1%. With “price” held almost constant from October 2007 to March 2013, the price-to-book ratio (PB ratio) of the US market has since fallen from 2.95X to 2.3X today, indicating that the US market is much cheaper at present compared to back in 2007.
Chart 3: S&P 500 Net asset value
In addition to profits and book value, revenues (or sales) of companies are a proxy of how well businesses are faring today compared to back in 2007. While some of the strong profit growth of US companies has been attributed to cost-cutting measures which has helped profit margins expand, it is also heartening to see that S&P 500 revenues have still managed to stage a recovery following the 2008-2009 recession, and presently reside at all-time highs as well. Compared against revenues in 3Q 07 (near to when the S&P 500 last peaked), revenue per share for S&P 500 companies is presently 18.3% higher, indicating that the value of goods and services sold by US companies have risen 18.3% since the last market peak.
Chart 4: S&P 500 Revenue per share
Markets can exceed previous highs, and they do
As discussed previously in How Does One Predict Equity Market Returns?, investors should remember than earnings growth is a critical component of stock market returns, alongside dividend yield and PE re-valuation; over the past 66 years (1946-2012), S&P 500 earnings have risen 7.2% p.a., fairly aligned with the 7.1% gain for the S&P 500 (excluding dividends, see Chart 5). It is thus more important to focus on the trend of earnings rather than price levels; it is on the basis of earnings growth that stock markets can make new highs and not be constrained by the highest index level achieved previously. Bearish sceptics or naysayers who argue that the “price” of the market is expensive today tend to ignore the fact that earnings and corporate value have grown substantially since 2007, justifying a higher price level for the market today.
Chart 5: S&P 500 performance and earnings
On market-timing and our approach to assessing “value”
The recent rapid ascent of the US market highlights that stock markets can move quickly when investors least expect it. With a host of ongoing economic concerns, most investors started 2012 with a rather dire outlook as they were overly-focused on the ongoing tirade of bad news (or on negative stock price movements), and were ultimately “surprised” by the strong gains racked up by various equity markets (see Top Markets of 2012: A “Surprisingly” Good Year for Equities) last year.
In contrast to the technical analysis which advocates investments solely on the basis of “price”, our approach is much longer-term in nature, requiring an emphasis on “value”. Even as stock prices underwent a period of weakness in 3Q 11, our valuation-driven approach suggested that most stock markets were highly attractive, warranting a broad-based upgrade for 12 equity markets under our coverage (Looking Past The Current Turmoil - Upgrading 12 Markets; Downgrading Europe). Since then, the US market has delivered a hefty 29.7% (in USD terms, or 34.4% on a total return basis), somewhat vindicating our upgrade of the US equity market back then. An equally-unpopular call back in October 2008 to upgrade the market (see US: Upgraded to a 4 Stars Market!) in the depths of the global financial crisis has reaped even better rewards for investors, with the S&P 500 posting a 62% return since then (in USD terms, or 78.8% including dividends). Our focus on valuations adheres to our logical “buy low, sell high” investment philosophy, which will continue to see us encouraging investors to buy more under bearish (and highly unpleasant) market conditions, while advocating that investors reduce exposure in richly-valued or exuberant markets.
Economic indicators we track point to better growth ahead for the US economy, spurred by an improving housing market alongside better job market conditions, and we believe that a combination of economic tailwinds and attractive valuations will continue to spur the market to further gains. At the time of writing (1 April 2013), we forecast a return of nearly 13% annualised (including dividends) for the market by end-2015, expecting market valuations to normalised to a conservative 15X earnings (a discount from the 16.3X long-term average) while the dividend yield on the market is expected to be in the range of 2.2% to 2.6% over the next three years. Despite the strong recent run-up in US equities to a new all-time high, we think investors should not be overly-worried about “price”, as valuation metrics we track suggest that the US market remains an attractive investment proposition today; we maintain a 3.5 star “attractive” rating on the market.