Thursday, August 7, 2014

Our latest valuation of S&P 500 ...

Let's discuss valuation of S&P 500.  For the next four quarters (including current Q3), we value S&P 500 at 1776, 7% lower than where it is today even after the 4% decline during the last two weeks.  

First, take a look at EPS estimates (bottom-up operating estimates) for CY '14 and CY '15 and see just how they have 'progressed':

Two things have not changed the last 18 months: 1) so-called 'analysts' have reduced their EPS projections for this year; and 2) 2015 EPS 1-year growth projection has been increased by only 6bps since Q1 '14.  Continuing reduction in EPS estimates has been going on for a few years.  So while growth projections keep getting pushed over to the next year, we would not be surprised if we saw 2015 EPS estimates continue to be adjusted lower going forward.  To give you an idea, in Mar. '13, 'analysts' expected 2014 EPS of $124.73, nearly 4.3% more than what they currently expect.  We must note one more thing displaying irrationality: the uber-optimism continues as while EPS and Y/Y growth projections were getting 'adjusted' lower, estimate of EPS 5-yr CAGR went up.  That figure has increased from 11.4% in Nov. '13 to the current 11.8%.  But let's move on.

S&P 500 is currently at 16x and 14x CY '14 and CY '15 EPS, respectively.  After hitting its record high of 1991.39 on July 24th, it has dipped 4%, but we think remains overvalued as QE policies are still priced in.  While we admit that we are not taking QE premium into account when valuing the market, we think this actually gives us an idea about what further tapering and higher interest rates can do, and what a bind the Fed is finding itself in right now. 

The S&P 500 index covers a pretty broad market, so we look for our forward P/E to represent a PEG (or PEGY) of 1.0.  Given that we can only work with the data we have, we are applying the 5-year EPS CAGR estimate of 11.82% plus current dividend yield (2.06%) to come up with our forward P/E of 13.88, applicable to 2014 and 2015 earnings estimates.

That multiple give us a 1657 - 1895 valuation range.  We are only in the second month of Q3 '14, and for this reason we took the median of that range, resulting in a 1776 valuation of S&P 500 for the next four quarters; approx. 7.0% below where the market is currently.

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