This Vexing Market

by Wayne Ferbert on October 2nd, 2013

I have really spent very few cycles thinking about the government shutdown. Wall Street tends to yawn its way thru them since most shutdowns last less than a month and the economic damage is usually minimized. This one will end similarly.
It is not the shutdown that has me so vexed. Instead, it is the question: is this market fairly valued?
We have written about this question several times in the last few months. Every time the S&P500 re-tests the $1700 to $1725 level, we discuss the relative merits of this market. As investors that prioritize value over momentum, we tend to get nervous when the market tests new highs.
Why are we nervous? Because we want to protect our wealth and we believe strongly in buying from pessimists and selling to optimists. That is a fancy way of saying that we want to buy our investments on the cheap and sell them when they look over-bought.
Our big problem right now: the case for saying this market is over-bought is not terribly strong. And the case for saying it is a buying opportunity is a weak case also. As a result, we feel stuck in the middle. Hence, it is a vexing market.
Look at the case for whether this market is over-valued. Despite the market being within a few percentage points of all time highs, the market is fairly priced on a Price to forward earnings basis. According to JP Morgan Asset Management, the forward PE of the S&P500 at the end of June was 13.9x while the ten-year average was 14.1x.
Also look at a few other value metrics compared to the 10-year average:
  • Price to Book: 2.4x vs. 2.5x
  • Price to Cash Flow: 9.4x vs. 9.6x
  • Price to Sales: 1.4x vs. 1.3x
  • P/E to Growth: 1.4x vs. 1.7x
  • Dividend yield: 2.2% vs. 2.1%
So, the current numbers are right in line with the 10 year averages. Has the market ever traded at materially higher multiples? You bet – which is why I am so vexed.
The 15 year averages are all about 10-20% higher for these metrics. Why? Because the 15 year window captures the Internet induced bubble of 1998 to early 2000. Multiples on value were at all time highs back then. As a result, I tend to focus on the 10 year averages.
So, we are in-line right now on the valuation side – but not terribly ahead of ourselves compared to where markets have traded in the past.
The amount of return premiums that investors expect from the market is what will really drive multiples in either direction. This is why the Fed monetary policy is so important. We need to remember that all return expectations for any investor start with consideration for the least amount of risk possible.
When money is cheap to borrow, investors have lower return expectations and will accept lower return premiums. Lower return premiums = higher multiples.
But in a rising interest rate environment, including a rising ‘risk-less’ rate of return, then the return premiums MUST rise. Rising return expectations will pinch PE multiples lower. But will the market likely really trade a lot lower than the PE level that is already in-line with 10-year averages. It has happened before – so don’t assume it can’t happen.
What is the Buy & Hedge conclusion? We like setting new hedges while the markets are within a few percentage points of all time highs. We are getting higher floors than ever before.
But to give ourselves room to run in our portfolio, our covered call strategy needs to go farther out on the time curve. We are looking at expirations AT LEAST 6 months in the future – and in some cases even further. In fact, we continue to match many of our laddered puts with a short call of the same expiration and lot size.
While we think the market is poised to take a breather, we are not prepared to invest like it will. The market is too vexing to make that conclusion. As a result, we will stay long – and hedged - and see where this ride takes us!

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