Another Way to Look at Valuations

The action in the stock market appears to be as confused as the message coming out of Goldman Sachs this week. If you will recall, it was Goldman's "valuation call" on Monday that sent stocks tumbling. Then on Tuesday, it was the wealth management arm of Goldman saying stocks are not overvalued and that clients should stay fully invested.

Although stocks rallied again on Wednesday (without the help of Goldman's guidance this time), the state of the market remains a bit of a question mark. In fact, the state of the market's trend depends entirely on which index one is viewing. For example, if you look only at the Dow Jones Industrial Average DJIA, you would conclude that stocks are in a downtrend. Yet, if you follow the Russell 2000 smallcaps IWM or the Midcaps MDY, you would contend that the market has recently embarked on a new leg higher. And if you spend your days looking at a chart of the S&P 500 SPY, your would likely conclude that stocks are in a trading range.

So, while we wait for traders to sort this thing out, we thought it would be a good time to finish up our review of the important market models - something we like to refer to as the "market math." Today, we'll explore another approach to looking at stock market valuations.

Building a Valuation Model

The idea behind using a "tree of indicators" approach (i.e. a market model) is to avoid the type of problems we saw in the GAAP P/E indicator in yesterday's missive. Unfortunately though, it doesn't matter currently whether you look at Price-to-Dividend, Price-to-Book Value, or Price-to-Cash Flow, the problem is the same - the data is all over the map and it is very difficult to draw any type of objective conclusions from the indicators.

So, one answer is to build a "relative valuation" model where valuations are compared to the level of interest rates. This takes into account the fact that when rates are low, valuations tend to be high and vice versa. This approach also appears to be able to adapt to a changing rate environment, which is a definite plus over time.

A Relative Valuation Model

Using a relative valuation approach, where one compares valuations to things like earnings yields, dividend yields, yield spreads, yields after inflation, etc., helps alleviate some of the problems that the last 20 years has created for valuation indicators.

For example, using a relative valuation model to produce buy and sell signals since 1965 has been fairly successful. 90 percent of the trades would have been profitable and the gain per annum using such an approach is nearly 50 percent higher than buy and hold. Oh, and the model has been on a buy signal since the summer of 2009.

Since 1965, when the model has been bullish, the S&P has gained at a rate of 13.0 percent per year and when the model is negative, the market has declined at an annual rate of -4.2 percent.

Thus, we can say that the model appears to do a decent job on a long-term basis both in terms of the spread of returns between positive and negative readings in the model and providing buy/sell signals.

However, this particular model tends to flash signals that can be very early. The sell signal prior to the technology bubble bursting in early 2000 came more than two years early. And in 1987, the signal came well before the market top.

It is also important to note that not all bear markets are accompanied/caused by extreme valuations. Thus, using this type of model alone would be a mistake.

Like the sentiment models though, a relative valuation model can provide a solid warning that a bull market may be nearing an end.

What Does the Relative Valuation Model Say Now?

Currently, the relative valuation model remains on a buy signal and in a bullish mode. This tells us that relative to absolute yields and inflation-adjusted yields, stock prices are not overvalued.

However, it should also be noted that the reading of the model has been steadily declining for the past two years.

Finally, it is also important to recognize that this type of model WILL be impacted by rising interest rates. And given that rates have been movin' on up since May and the Fed will continue to reduce their bond-buying program, most analysts believe that rates have nowhere to go but up (anyone care to play contrarian here?).

In summary, the valuation debate is likely to rage on as there is no clear-cut answer to be gleaned from a myriad of indicators.

The bears contend that the combination rising rates and historically high multiples will eventually come home to roost. As a result, the-glass-is-half-empty crowd, as you'd expect, isn't high on the prospects for stocks in 2014.

However, the bulls remind us that positive market environments tend to last longer than most can imagine, that rates remain historically low, that inflation is nowhere to be found, and that the trend is your friend.

The Final Takeaway

As we've opined recently, our view is that stocks are likely due for some sort of meaningful pullback at some point in 2014. And our ultimate takeaway from our review of the "market math" tells us that this is an environment where it makes sense to play the game more cautiously and with an eye on the exits.

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