SB: Monday Morning Musings - Unscrambling the Valuation Puzzle 07:02am EST 4-Mar-02 Salomon Smith Barney (Tobias M. Levkovich) SALOMON SMITH BARNEY Industry Note
Institutional Equity Strategy Monday Morning Musings - Unscrambling the Valuation Puzzle
March 4, 2002 SUMMARY * As we see it, many people mistakenly believe that Tobias M. Levkovich the market P/E is too high relative to history. * Low inflation is one buoy to higher P/E's and we would also remind investors that median multiples are not outlandish. * The valuation dichotomy within the S&P 500 becomes very apparent when looking at the P/E's of the ten major sectors and by breaking the S&P 500 into quintiles. * ISM new orders was at its highest level since 1994 and was the third month in a row above 50. * We can see the grounds for a continued market rally led by the Industrials, Financials and Consumer Discretionary sectors. OPINION
We believe many professional money managers and individual investors have been suffering from a common misconception of late. In fact, we believe that it has led to delusional views regarding the equity market and has caused errors in judgment. In particular, we see a general misunderstanding of the stock market's valuation levels as numerous members of the investment community presume that the market P/E is too high based on historical context.
Specifically, when reviewing historical market P/E ratios (Figure 1), one can see that the S&P 500 is trading well above its past 10-, 20- or 30-year averages. Moreover, even after the market's correction from highs experienced in early 2000, the S&P 500 is still trading at roughly 23x anticipated 2002 EPS estimates, well above the 7x multiple at the trough of the market in 1974 and 13x following the 1987 market crash. Therefore, it is easy to conclude that these exceptionally high P/Es cannot last and that the market will pull back or that earnings climb alongside production increases this year but there is no commensurate equity market appreciation, thereby causing P/E multiple contraction.
The Market Is More Reasonably Priced Than It First Appears
First impressions, while often lasting, can also be misleading. In our opinion, that seems to be the case when one reviews the equity market's P/E ratio. At first glance, the market appears to be richly valued, but one must better understand the underlying inflation environment. As can be seen in Figure 2, the market's P/E is related to inflation rates. And when we attempt to remove the tech bubble's impact on the market's P/E by using median P/E ratios (Figure3), we find a similar relationship. Thus, at 12% inflation rates, a 7x multiple in 1974 is not unreasonable while 4% inflation might yield a 13x multiple as was the case in 1987. But when assessing an anticipated inflation rate below 2% (based on the current 1.7% spread between the nominal yield on 10-year Treasury notes and the inflation indexed TIPS yield), a 23x multiple is quite rational. Moreover, when looking at the market's median multiple of 19.5x estimated 2002 earnings, stocks appear fairly reasonably priced.
In fact, if one looks at the various sectors within the S&P 500 (Figure 4), the weighted valuation dichotomy becomes even more apparent given the sky high P/E ratio found in the Information Technology sector which commands a more than 40x ratio. Thus, if just the tech stocks' P/Es contracted, the overall market's multiple would come down. Hence, if we are worried about excessive valuation, one has to understand where that discrepancy lies.
Furthermore, if one dissects the companies within the S&P 500 into quintiles, it is clear that the top quintile trades at the high multiples (Figure 5) while the next 400 names do not. Accordingly, as the old adage goes, "never judge a book by its cover!" But before, one jumps to the simplistic conclusion that the weighting of the market P/E is just a market capitalization issue, we would emphasize that the arbitrage that existed last year between large cap stocks' multiples and small caps has closed markedly (Figure 6) with small caps more highly valued today than the S&P 500.
To be candid, using a P/E valuation metric alone is not always appropriate, but we do think that the above discussion is important in separating conventional wisdom or market perception vs. fundamental reality. As we have discussed on various occasions in the past, informed investors have the opportunity to make money exploiting the gap between unfounded perception and underlying reality, and we consider the high P/E argument to fall into that category.
The Earnings Yield Gap Remains Attractive
In early April and late September 2001, we argued that investors should buy stocks based heavily on vacillating investor sentiment and highly attractive valuation when looking at the earnings yield gap (Figure 7). In fact, at more than two standard deviations below its five-year mean, we had a fair degree of confidence at those times that equities would outperform debt instruments. Now, at only one standard deviation below the mean, stocks are attractive but not as much as they were in those previous periods. But, as we have tried to argue for the past couple of weeks, we believe that earnings visibility is improving alongside indications of economic expansion and rising orders. Therefore, when we juxtapose earnings growth expectations and continued investor skepticism (in view of accounting concerns and the losses following the dot-bombs), we can see the grounds for another market rally. Indeed, the economic conditions improvement is not just a domestic event, with Germany (Europe's largest economy) and France experiencing their fourth month in a row of growing business confidence.
Note that the ISM new orders index at 62.8 was at its highest level since 1994 and was the third month in a row above 50, highlighting expansion. We believe investors will begin to hear more confirmation of this industrial trend from more companies in the next few weeks, which may drive the market even higher. Thus, we do not view Friday's rally to have been the main event. Investors have been seeking orders data to get earnings visibility and they got an eyeful with the ISM.
Consequently, we believe that the equity markets have further appreciation potential led by the Industrial, Financials and Consumer Discretionary sectors. As cyclical conditions continue to improve, we think that stock prices can climb roughly 20% in the next few months and we would not be deterred by unsupported valuation contentions. Hence, we are maintaining our S&P 500 upside target of 1300-1350 this year.
Finally, we would point out that while we expect tech stocks to participate, at least near term, in any equity market gains, we strongly doubt that it will be the market leader it once was. In addition, cyclical conditions do not favor defensive sectors such as Health Care and Consumer Staples given relative earning growth. Thus, we are retaining our Slight Underweight posture on these two areas. |