By Costas Bocelli - Creator: Channel Trading Secrets
The major averages just hit the trifecta earlier this week...The Dow traded to 16,000. The S&P 500 hit 1,800. And the Nasdaq Composite came within an eyelash of poking through 4,000.
Those are big round numbers, and with them have come plenty of attention that suggests stocks are now ridiculously overpriced and hitting bubble territory.
Perhaps if you look at the latest craze to hit Wall Street, like the social media space, I would tend to agree. Companies such as Facebook (FB), LinkedIn (LNKD) and Twitter (TWTR) are trading at astounding valuations because of the aggressive growth potential that is anticipated there in the coming three to five years.
Enthusiasm has become so perverse that investors are paying very high premiums, believing those expectations will eventually lead to massive profits.
And because of this, many are now trading with multi-billion dollar market capitalizations.
That seems to be quite excessive when you consider that the barrier to entry in the space is rather low. And while many of these companies have successfully carved out their own unique niche in the social marketplace, the reality is that their business models are very much alike and are essentially chasing (and competing) for the same sources of revenue -- advertising sales dollars.
I may be proved wrong, but to me, this sector passes every test of what a bubble tends to look like. There may be several more breaths to be blown, but... don’t forget to cover your ears when it finally pops.
However, social media stocks only represent a small segment of the entire equity market. And I have to tell you, if you ignore all the media hype and attention that these crazy highfliers are getting, the broad markets remain relatively balanced and still attractively priced, even at current levels.
Let me explain...
There are two things that really reinforce my belief that the US equity markets are not anywhere close to hitting bubble status, and that they still provide an excellent opportunity to invest over the medium to longer-term.
The first thing is pretty straightforward, and that’s valuation.
With Q3 earnings season now in the books, and just six weeks left until the end of the year, analysts have a pretty good idea that operating profits for the entire S&P 500 should materialize in the $110 per share range. That means that the index is currently trading with a trailing price-to-earnings (P/E) multiple of about 16.
But the market is a discounting mechanism and tends to look forward rather than backward. Over the next four calendar quarters, operating earnings are projected to grow by about 9% to $120 per share, which means that the S&P 500 is trading with a forward multiple of 15.
And that valuation is pretty much the average for the index -- so it’s not cheap, but not expensive either as compared to historical performance.
And even though the S&P 500 is at an all-time historic peak, the valuations are still below the other significant record tops dating back to the early 2000's.
Revenue growth continues to be a primary concern over the coming quarters, but operating earnings have been helped by cost cutting measures and stock buyback programs which are accretive to earnings per share. Non-financial companies in the S&P 500 have roughly $1.5 trillion in cash on the balance sheets and are using that cash to boost the bottom line.
Companies like International Business Machines (IBM) are struggling to grow profits are using their cash on hand to buy back their stock and increase profits as a supplement. Obviously this can’t go on forever, but over the next four to six quarters, cash is helping to drive profits as global growth continues to recover from the great recession.
The other thing is the favorable interest rate environment.
Thanks to ultra-accommodative monetary policy, the Federal Reserve has artificially lowered long-term interest rates through their QE asset purchase programs.
But Wall Street had another taper tantrum yesterday afternoon as stocks turned negative shortly after the minutes were released from the October FOMC policy meeting.
The Fed continues to signal that it expects to begin reducing the monthly pace of its bond buying program “in the coming months”. Currently, the Fed is buying $85 billion a month in bonds and several members indicated that a reduction could occur as early as next month.
But that seems unlikely considering the latest data on inflation. Consumer prices are rising at annual rate of just 0.9%, which is the weakest in four years. That’s far below the Fed’s targeted mandate of 2% inflation and a valid reason to continue the current pace for longer.
Unless the November jobs report shows a huge number of jobs added to the economy (250K+), a December taper should be unlikely and pushed off into early next year.
However, the Fed remains “committed to accommodative policy for as long as needed”. Chairman Bernanke reiterated his pledge earlier in the week and his likely successor, Fed Chair nominee Janet Yellen, affirmed it as well in her confirmation testimony on Capitol Hill last week.
In essence, the Fed is committed to keeping short-term interest rates pegged near zero for a very long time, and their accommodative forward guidance should also pressure longer-term interest rates to a measurable degree.
Putting the Two Things Together
It’s important to understand that abnormally low interest rates are extremely favorable for stocks.
Consider the US 10-year Treasury note, which is yielding 2.80%.
Now let’s turn back to the valuation on the S&P 500 that we had discussed. Do you recall the forward P/E that is expected on the index? That’s right -- the index is trading at a forward multiple of 15 times earnings.
If we flip the ratio upside down or simply divide 100 by the P/E of 15 you get 6.7. That’s essentially the earnings yield (expressed as a percentage), or risk premium, for holding stocks.
Now compare potential returns of 6.7% in stocks versus the 2.8% in fixed income 10-yr Treasuries. That wide differential in the spread is what really makes investment in stocks very compelling, and until that relationship narrows it’s going to be a major driver for cash flowing into the equity markets.
S&P 500 companies are also distributing cash dividends back to shareholders at an all-time nominal high, and at current valuations the cash payouts equate to annual yields of 1.90%.
No Bubble Here
Looking for value?…Then look no further.
Consider Deere & Company (DE).
(John) Deere is one of the world’s largest manufacturers and distributors of agricultural and construction machinery.
The company just announced earnings yesterday morning and easily beat analyst estimates for the completed quarter. Management is also upbeat looking ahead as it raised its expected profit estimates for the 2014 fiscal year.
The stock trades with a P/E multiple of just under 10 and currently distributes a quarterly cash dividend that’s yielding 2.5% (almost the equivalent of a 10-year treasury note).
Technically, the stock is trading well off the highs and finally seems poised for a lift after several months of consolidation along the low end of the trading range.
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Costas began his trading career in 1998, at Gateway Partners, an Equity Options Trading Specialist Unit on the Philadelphia Stock Exchange (PHLX). During his successful tenure, and though unprecedentedly volatile trading levels, Costas boldly and adroitly navigated the global "financial meltdown" that saw the downfall of the hedge fund and of Long Term Capital, and the Russian Currency Crisis. Having achieved the coveted Senior Equity Options Market Maker position for his firm, Costas eventually left to join a proprietary trading desk, where he successfully makes markets for large customer and institutional orders. In addition to his more than 7 years of experience as an options market maker, Costas has also trained and educated many junior traders on option theory, risk analysis, and strategy. His passion is helping self-directed investors achieve all of their financial goals through a clear, practical understanding of the power of options and of the many benefits of trading in a proven systematic way. |
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