Today’s epic melt up has left many traders, investors and market watchers speechless. But even prior to Wednesday’s explosive move higher, the market was already in nosebleed territory.
As Bank of America calculates, as of yesterday’s close, multiples expanded across most sectors and across all size segments in November. The S&P 500 forward P/E of 16.7x is back at September-end levels (10% above average), while the trailing P/E of 21.6x is at its highest levels since late 2009 (nearly 20% above average). Valuations for the index look elevated vs. history across most metrics (Table 2), though a still-elevated equity risk premium suggests stocks continue to look attractive vs. bonds. And large caps now look attractive vs. small caps, where the Russell 2000’s forward P/E jumped to a 20-month high in November, its biggest one-month increase since 2009.
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 17 of them by as much as 76% (on a historical market cap to GDP) basis, and is cheap only according to trailing normalized PE (18.5x vs 19.0x average), Price to Free Cash Flow (23.1x 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.
Ok fine, the market is cheap, and on the 20th anniversary of “Irrational exuberance” it is going for try #2. However, is every sector overpriced? Here, some opportunities emerge: Health Care is now the cheapest sector vs. history on all three relative multiples tracked by BofA (forward P/E, Price to Operating Cash Flow, and Price to Book), and all industries within Health Care are trading at a discount to history on both relative forward P/E and P/OCF— especially Biotech, which trades at a 30% discount to the market’s P/E vs. a 30% premium historically. After today’s Trump comment it is trading even cheaper. While Health Care’s multiple had collapsed to multi-year lows on election risks, the sector barely re-rated last month despite the removal of this uncertainty overhang. If multiples were to revert back to their L/T average, this would imply over 30% upside.
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 47%.
So what does this mean in terms of recommendations from BofA? Well, the answer is, “its complicated.” During a press event in NYC, BofA’s head of U.S. equity, quantitative strategy Savita Subramanian, said that her outlook is “bifurcated.” The truth, however, is that Savita is right – at this moment the market can go straight up, or it could crash, both with equal probability, based on what happens to Trump’s proposed policies. As she notes, “we’ll know if we’re getting a bull case if Trump administration tax reform, infrastructure spending are “penciled in” in first couple of quarters.”
What she is concerned about is company capital raising – it would would be negative if corporations can’t raise capital via IG issuance – as well as “rhetoric” out of Washington D.C.. She urges to watch potential recession indicators for signs of risk.
What is the upside case? For S&P 500, Savita’s year-end bull case is 2,700, however it would need continued rotation to equities from fixed income. She notes that she is watching sell-side equities allocations recommendations, which are currently ~51.5%. If strategists’ recommendations rise to 60%-65%, would see it as “all in.”
What is the downside case? The bear case would include trade wars, stagflation, rates either rising quickly or not at all. It would also mean the S&P dropping to 1,600 or lower. To confirm a bearish case, watch recession indicators such as the 2/10-year yield curve, ISM, building permits, temp help job growth, and C&I loan growth.
So, a year end S&P range from 1,600 to 2,700. Let’s just call that… wide.
She also noted that share buybacks are at all-time high, but starting to slow, and while she sees potential for infrastructure spending under Trump administration, it is now “quite aggressively” priced-in to exposed stocks (materials, building products, cement, industrials), and sees these as better candidates to short than go long long.
Finally, she said she was watching company leverage, which as we have documented repeatedly, is at all time high, or as she put it, it “has been a very friendly environment for borrowing.” Should this change abruptly for whatever reason, it may signal the next fundamental regime change.
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