Here’s Where to Invest When Markets Overvalue

March 15, 2015 • Analysis • Tags: , , ,

  • Median indicators, such as the median P/E & P/CF ratios of stocks on the NYSE, are showing that markets are at historic overvaluations. Not a very appealing risk to reward payoff for investors.
  • Small-cap stocks underperformed their larger counterparts significantly in 2014, so the there is greater choice for investors seeking value.
  • Emerging markets, such as India, have had recent catalysts that could be the roots for alluring investment opportunities.

The S&P is officially down for 2015 after markets slid 1% this last week. With many companies sporting high valuations, it’s become increasingly difficult to find value investments. When compared to historic figures, current markets are indicating they’ve reached an expensive peak. For Last Financier, this isn’t necessarily bad. We’ll explain why.

US Markets Reaching Historically Elevated Valuations

SP 500 P.E Multiple

Market supporters argue that the S&P 500’s trailing P/E is only 17x, pointing to the 30x ratio that the index touched during the dot-com bubble (chart above). According to this, stocks have much more room to run. If we were to look from a different perspective though, stocks would appear way more expensive.

The Median Measure

By definition, the median is the number that separates the higher half of a data sample from the bottom half. It’s the 50th percentile.

SP 500 Median P.E P.CF

The median NYSE multiples (above), rather than the aggregate multiples used in Graph 1, indicate extreme valuations are spread across broad markets. Why? Because:

  • At least 50% of stocks on the NYSE are trading above P/E ratios of 20
  • At least 50% of stocks on the NYSE are trading above P/CF ratios of 14x

These figures have never been higher in history. You may think that Graphs 2/3 are baseless because of the low valuation metrics they depict for the years 1999-2000, when markets were at a peak. The answer to that is the difference between a concentrated / wide spread overvaluation, which are thoroughly explained by Wells Capital Management in this report.

Concentrated valuation extremes occur where only a certain sector of the market is extremely overvalued. This is what happened during the dot-com bubble with technology sector. As shown in Graph 1, aggregate P/E during this time was 30x. The median P/E (Graph 2) in year 2000 was actually less than 15x. In other words, the bottom half of the NYSE had a P/E of less than 15x. Technology stocks received unreal valuations that drove the overall market metrics. Other sectors remained “valuable”.

Fast forward to today’s market and we have the opposite: a broad based extreme valuation. Equity valuations are high across the wide spread market. In other words, the whole market can be considered overvalued as it’s not only one sector, but rather every sector. This limits investors in diversifying into a cheaper sector. Median P/E and P/CF are at all time highs (above). Even though aggregate P/E is 17x, median figures are 20x. Same pattern with P/CF, in which the median is almost 15x P/CF.

Why Is This Good for Last Financier?

Unlike the majority of investors, we aren’t too interested in the large cap universe. The above mostly applies to that area of market. Small-cap stocks underperformed the S&P 500 Index significantly in 2014, so there is greater value choice. We know from personal experience. Check out one of our best performing picks Ebix (EBIX). The stock is:

  • Up 120% since we initiated coverage in mid-August
  • Up 74% YTD
  • Up 15% on Friday after earnings beat

Read our latest take on Ebix here

What Are Investment Alternatives?

US Treasury rates are at ~2.1% and core inflation is 1.6%. Thus, no real gains to be made in fixed income. Maybe this area could become attractive if/when The Fed raises rates. US equity markets are priced rich, so anyone taking a dive is doing it with lots of risk.

When asked, we tell people to either look at the small-cap universe, as mentioned above, or emerging markets. India, for example, has taken monetary actions to revive its economic growth. With a fast growing middle class and investment friendly government in place, things are looking up for India as an industrial play.

Read our analysis on India’s economic resurgence here.

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