Last updated: 12:32 / Friday, 4 April 2014
MFS Investment Management

Are Stocks Getting Stretched?

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Are Stocks Getting Stretched?

Last month we observed the fifth anniversary of the US equity bull market, which started after the S&P 500 Index troughed at 676 on 9 March 2009. With events in Ukraine and other geopolitical hotspots to distract us, we may not have celebrated with cake and candles, but we’ve reached an important milestone.

Are we on track for another year of stock gains, or have we reached the market top? Let’s take a look at some equity valuation measures to see where we stand.

Stock market fairly valued?

Valuations continue to be front-page news. Certainly commentators are saying that valuations are stretched, especially in a fragile macro world. But if we compare valuation metrics today with the two previous market peaks, we can see that the private sector is in much better shape this time around:

 

I would like to point out that earnings per share (EPS) are notably higher, while the trailing price-to-earnings or P/E ratio of the market is not yet at the levels we saw at the tech bubble’s peak in March 2000 or even in the not-so-bubbly October 2007. Other trailing measures also suggest that valuations are not overextended.

What about indicators that look ahead, rather than behind us? If we consider the forward P/E based on analysts’ estimates of earnings over the next 12 months, we find the market in roughly fair value territory:

To account for the ups and downs in the business cycle, we can adjust earnings by looking at the Shiller P/E, which uses the 10-year moving average of earnings adjusted for inflation. By this measure, the market looks a little expensive:

But if we look at some other measures, such as the inflation-adjusted dividend yield or the free cash flow yield that many analysts follow, the market looks cheap. So on balance, I would say that the market’s at fair value.

Evidence from credit markets

I also look to the credit markets for forward indications of where stocks may be going. As I’ve discussed before, spreads in the bond market are the price that corporations have to pay for credit. We’ve seen those spreads stay steady or even narrow. My colleagues at MFS are experts in the credit sector, and our high-grade and high-yield bond analysts and portfolio managers are telling me that these markets are signaling better times ahead.

So to those who claim that the easy money from the US Federal Reserve is propelling equities beyond reasonable pricing, I would respond that the market at this point is not overvalued due to excess liquidity — especially good news now that the Fed’s communications have become a bit more hawkish than we might have expected. And narrower credit spreads, as we’re seeing now, have tended to be pretty good indicators when other risky assets — like stocks — aren’t under pressure.

Article by James Swanson, Chief Investment Strategist, MFS

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