Saturday, May 11, 2013

Is S&P 500 Overvalued?

As more than 90% of the S&P 500 companies have reported Q1 results, combined with continuation of modest economic recovery, and state of employment being in a slightly better shape than we have been projecting, we thought to take a look at the S&P 500 to see whether it is undervalued or not.  In our opinion, it is overvalued.  

Let's start with 2013 projections.  According to S&P, 2013 S&P 500 EPS (operating income estimates from bottom up) are expected to grow 13% Y/Y.  This growth is partially driven by the overall economic recovery; however most of it is from margin expansion, which is due to company cost-cutting measures and not necessarily top-line growth.  But let's say, demand increases and companies will be generating higher revenues.  Unfortunately, given the significant cost cutting measures implemented the last 5 years, increase in demand will demand higher costs such as increased headcount.  What will keep cost increases somewhat in check will be continuing stagnation in wage growth.  We note that although commodities have taken a hit recently, any further confirmation of continuing economic growth will push them up again, increasing costs for companies.  In addition, many geopolitical factors are still in play.  While capex and other investments may increase, which is good news, again, we think it will be limited.  It will be tough for public companies to show shareholders that the bottom-line can continue to grow.  Of course, many could change their accounting methods and make those non-GAAP EPS look good, but that's another topic for another time.  

So we could basically see modest increase in demand, higher headcount, lower margins, and not much of an increase in consumers' disposable income.  Simply put, at least in the short to medium term, higher demand might be costly for many companies.  All of this will make the continuation of strong EPS growth less likely. 

Based on where the S&P closed at on 5/10, it has a forward P/E of 14.9, based on 2013 EPS projections.  We think this indicates that the index is overvalued.  Based on the 5-year CAGR consensus of 10.7% and a 2.1% annual dividend yield, we think S&P 500 should be valued at approx. 13x 2013 EPS, or at around 1429.  This represents a PEG of 1.0.  At 1633.70, the index is 14% above what could be its fair value based on 2013 numbers.  Obviously, there is a QE premium built into this.

Now, given that we are almost half-way through 2013, let's look at 2014.  Based on the $123.13 EPS estimate, it appears that only 12% Y/Y EPS growth is expected in 2014, lower than this year's 13%.  This goes along with what we mentioned earlier regarding lack of further significant margin expansion going forward.  Given declining bottom-line growth, we think the P/E (along with the dividend yield) should represent a PEG of slightly below 1.0.  We applied a mere 5% discount to our 2013 13 EPS multiple, which resulted in a 12.35 P/E.  Applying this to 2014 EPS estimate, gave us a valuation of approx. 1521 for the S&P 500, representing a 7% downside from where the index closed on Friday. 
We still have half of 2013 ahead of us, so we took the midpoint of our estimates, 1475, as our projected fair value of the S&P 500 for the next 12 - 18 months, representing a 10% downside. 

There are certainly other factors that can push the S&P 500 much higher or lower.  They include continuation (or not) of the Fed's QE policy, improvement (or not) of the state of the economy in the EZ, potential stability (or not) in the Middle East, and many other factors.  However, we think the Fed should be thanked for such a huge premium that we are seeing when it comes to the value of the equity market.  Unfortunately, its time will come, and we and the market will have to adjust.  As the economy keeps improving and as Bernanke will be trying his best to avoid the creation of another bubble, we think we are getting closer to that time.  From a fundamental standpoint, the S&P 500 should be valued at around 1475 during the next 12 - 18 months, in our opinion.

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