Despite the recent modest profit-taking in the S&P 500, the market - just shy of its all time high 2,400 level - remains in nosebleed valuation territory.
As Bank of America calculates, in March the S&P 500 forward P/E was little-changed amid a flat month for stocks, and at 17.5x continues to trade at its highest levels since 2002 (on a trailing basis P/E is at 19.6 and 29.0 based on the Shiller PE). This is almost one turn higher since we last performed a similar valuation exercise back in December.
Hardly a bargain, stocks remain stretched vs. history on the majority of metrics Bank of America tracks (Table 2) and as Savita Subramanian points out, the only way stocks still look cheap is relative to bonds. While BofA is quick to warn that today’s elevated valuations suggest longer-term caution on stocks, it reminds clients that "valuations typically matter little in the final stage of a bull market during which sentiment and positioning are the key drivers of returns." This is also known as the so-called "just buy everything" cop out.
Stripping away BofA's subjective commentary, to allow readers to decide for themselves whether stocks are massively overvalued and overbought, or perhaps cheap, here is a breakdown of the S&P 500 across a wide variety of valuation measures — 20 in total — to gauge whether US stocks look cheap vs. history. What the analysis shows is that of 20 metrics, the S&P is overvalued based on 18 by as much as 85% (on a historical market cap to GDP basis) and up to 105% if looking at the S&P in WTI terms, and is cheap only according Price to Free Cash Flow (25.1x vs 28.4x) which however is a function of ultra low interest rates, and also based on a ratio of the S&P-to-Russell 2000 fwd PE multiples. A third metric which last December suggested stocks were "cheap", namely trailing normalized PE (19.6x vs 19.0x average) flipped to "rich" in the past 5 months.
And while the broader market may be the most overpriced in 15 years, some bargains can still be found. A detailed breakdown shows that multiples were little-changed across most sectors last month, with the biggest relative multiple contraction in Financials (-3%) and the biggest relative multiple expansion in Discretionary (+3%)—but both sectors trade roughly in-line with history on relative P/E. Several sectors do offer sizeable upside or downside opportunities if multiples mean-revert to their long-term averages. For those seeking potential longs, BofA finds that the biggest mean-reversion opportunities are the defensive and bond-proxy sectors and Tech. Despite seeing its P/E creep up to its highest levels since 2010, Tech still trades at more than a 10% discount to history (even ex. the Tech Bubble). For those seeking to pair a long with a short sector (as nobody apparently trades single-names any more and everything is done by ETF), see Table 1 below.
What is expensive: according to the three chosen valuation metrics, Consumer Discretionary, Energy, Materials and IT are the most overvalued, in some cases by as much as 33%.
So what does this mean for BofA's market recommendations? For the answer we bring readers back to Savita Subramanian's March 1 note in which the analyst, already brimming with optimism from her Barron's round table discussion in December, raised her S&P price target from 2,300 to 2,450, although with many caveats.
Here is what she said 6 weeks ago; she has yet to change her thesis, perhaps because as she admits, "valuations typically matter little in the final stage of a bull market during which sentiment and positioning are the key drivers of returns."
Raising 2017 S&P 500 year-end target to 2450
We are raising our 2017 year-end S&P 500 target to 2450 (from 2300), driven by two changes: (1) we lower our end-of-year equity risk premium (ERP) assumption to 400bp (from 450bp), and (2) within our five-factor framework, we adjust our fair value model weight lower in favor of our sentiment model. These changes reflect an increasing likelihood that we are entering the typical later stages of a bull market, during which fundamentals typically take a back seat to sentiment and technicals. We think the market still has the potential to move higher as investors capitulate into equities; note that the “Great Rotation” out of fixed income into equities has yet to happen. But as we noted in our Year Ahead, we see a wide range for 2017, and investors are likely better served focusing on the internals of the market rather than on a year-end number. And for longer-term investors, elevated valuations and high leverage today shift the risk-reward balance for the market to more risks than were evident a few years ago.
The stock market has always seen outsized returns leading up to its eventual crash, and we think this time will be no exception. In addition to lowering our end-ofyear equity risk premium (ERP) assumption to 400bp (from 450bp), we are adjusting our fair value model weight lower in favor of our key sentiment model. As a result, we are raising our 2017 year-end S&P 500 target to 2450 (from 2300), which implies a better than 75% probability weighting of our 2700 bull case scenario and less than a 25% probability weighting of our 1600 bear case scenario.
We expect the market to overshoot its fair value
Typically, in the later stages of a bull market, corporate earnings are cyclically elevated and the multiple that the market assigns to those earnings is often elevated as well. As a result, market prices can become significantly overvalued relative to their intrinsic fair value, and this divergence can last for years. Thus, we would highlight the distinction between our year-end target of 2450 (driven largely by sentiment and technicals) and our estimated intrinsic fair value of 2230. For investors with long time horizons, our long-term (year 2025) target of 3500, which is based solely on valuation, indicates a solid but below-average annual price return of 4-5% (or total return of 6-7%).
Watch out for volatility when the “Trump put” expires
We would expect the rally in lower quality stocks to fade as we get more clarity / details of potential stimulus and tax reform, where expectations today are quite optimistic relative to the likelihood of delays, friction and more negative offsets than the market is currently pricing in. Meanwhile, economic surprises are close to a five-year high and we expect S&P 500 earnings growth to decelerate in the second quarter. While we see further room for market sentiment to improve, the market may take some time to digest the recent surge in optimism before heading higher. So while we expect stocks to end the year higher than where they are today, the road could get bumpy as we head into spring and summer months. As such, we see an elevated probability that the market falls below our 2230 fair value estimate before the end of the year.