Another Take on Valuation - It's Not As Bad As You Might Think

Yesterday's dive in the high profile FAANGs, which was highlighted by a $7.87 (4.49%) decline in Facebook (NYSE: FB) led to renewed discussion in the bear camp about the risk levels in the overall market. To hear the our furry friends tell it, yesterday's decline was a harbinger of bad things to come (yes, the term "tech wreck" is back) and that market risks are about to come home to roost.

On the subject, I was asked yesterday for specifics on why I believe that risk factors are elevated in the stock market. The first bullet point I listed was the issue of stock market valuations.

As I detailed last week in a missive entitled, Understanding the Elevated Risk Concept, it is very hard to argue that stocks are not expensive in terms of traditional valuation metrics such as Price-to-Earnings, Price-to-Cash Flow, Price-to-Sales, Price-to-Dividend, etc. The bottom line here is that current valuations are either at or near levels that have led to large declines in the past.

Because of this situation, the thinking seems to be that we are headed for another 2000-02 or 2008-style debacle in stocks. And with the FAMANGs (I've added an "M" for Microsoft) getting blasted to the downside yesterday, well, one bearish narrative seems to be that tech stocks are going to lead the parade to the downside due to what was referred to yesterday by one advisor as "insane valuation levels." Makes sense, right?

Just The Facts Ma'am

However, I quickly pointed out that if one looks at valuation levels of the major market indices, this view is flawed. In fact, the tech-heavy NASDAQ 100 is actually less overvalued relative to historical levels than the S&P 500, the Russell 1000 Value, and the Russell 1000 Growth.

I recognize that such a statement requires some "esplainin," so let's look at some details.

According to a September 8 report from Invesco, the NASDAQ 100 trades at a forward P/E ratio of 21.7. To be sure, this sounds high. However, Invesco says that the 15-year average for this multiple is 20.1. Therefore, the NDX is currently trading at a "valuation premium" of 7.9% relative to its 15-year average.

Now let's compare this to the same metrics for the S&P 500. Invesco reports that the blue-chip S&P index currently trades at a forward P/E of 18.8, which is clearly lower than the 21.7 seen over on the NDX. However, the 15-year average forward P/E for the S&P is 15.4. This means that the current "valuation premium" relative to the historical average is 22.2%, compared to 7.9% for the NDX.

Next, let's look at a "value" index for comparison purposes. After all, with the exception of the brief post-election run, value stocks have largely been out of favor for some time. Thus, one might expect to see better valuations here. And the forward P/E of 17.0 for the Russell 1000 Value (aka large-cap value) would seem to bear this out. But, the song actually remains the same when you look at the "premium" of the current forward P/E relative to the last 15-years, which is 19.1%. Thus, it appears that the "valuation premium" on the value index is also much higher than that of the NASDAQ 100 (2.4 times higher, to be exact).

And finally, let's compare the valuation levels of the Russell 1000 Growth (aka large-cap growth). Since the large-cap growth arena has been where the action in the market has been for some time now, it shouldn't be surprising to learn that the forward P/E on the Russell 1000 Growth index is 22.3 - the highest of the bunch. And given that the 15-year average for this index has been 17.6, this means that the "valuation premium" (again, relative to the historical average) currently stands at 26.3% - or 3.3 times higher than the 7.9% premium of the NASDAQ 100.

This data suggests that the forward P/E for the technology-ladened NASDAQ 100 is indeed elevated here due to the fact that the current forward P/E is 7.9% above its 15-year average. However, the degree of overvaluation relative to the last 15 years is actually lower - no, make that, much lower - than the overvaluation levels of the S&P 500 and the Russell Large-Cap Value and Growth indices.

The Takeaway

For me, this batch of statistics was an eye-opener because I too assumed that the valuations of the leading index were probably sky high. And while I am quite sure that the bears will be able to come up with examples of stocks trading at scary-high readings, at the index level, the fact is that the valuation of the NDX isn't off the charts at this time.

Make no mistake about it; the valuation game is tricky at best. And one thing that I've learned over my 30-year career managing other people's money is that valuations rarely CAUSE a severe decline. No, in my experience, the bears usually need a catalyst to get the party started to the downside. And currently there just doesn't seem to be one.

The key, again, in my opinion, is that declines that occur when valuations are elevated tend to be more severe. I liken this to the risk of falling off a ladder while standing on the second rung to falling from the top of the ladder.

So, the bottom line is that, as I've been saying, "risk factors" are elevated at this time. Put another way, this is not a low-risk environment. But since valuations don't generally cause bear markets, this, in and of itself, is not a reason to run and hide. My take is that this is simply a time to be careful with the degree of risk you are taking in your portfolio.

As always, my game plan it to attempt to stay in line with the overall market conditions. And for me, this means curbing my enthusiasm - at the very least until the period of negative seasonality passes.

Thought For The Day:

Just for fun, try smiling at everyone you meet today.

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

1. The State of the Tax Reform

2. The State of the Economic/Earnings Growth (Fast enough to justify valuations?)

3. The State of Geopolitics

4. The State of Fed Policy

Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Sowell Management Services

Disclosure: At the time of publication, Mr. Moenning and/or Sowell Management Services held long positions in the following securities mentioned: none. Note that positions may change at any time.


The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

David D. Moenning is an investment adviser representative of Sowell Management Services, a registered investment advisor. For a complete description of investment risks, fees and services, review the firm brochure (ADV Part 2) which is available by contacting Sowell. Sowell is not registered as a broker-dealer.

Employees and affiliates of Sowell may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time.

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Posted to State of the Markets on Sep 26, 2017 — 9:09 AM
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