Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

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EQ: Less than two weeks ago, we discussed the possibility of whether the recent dip from the late-July high was the start of the long-awaited pullback or whether it was just noise. With the S&P 500 back within striking distance of the all-time high, was that another false alarm?

Stovall: Apparently so. Another false alarm was what investors had to go through over the past couple of weeks. Now, with the bouncing off of the 50-day moving average and advancing quite strongly and broadly, I would tend to say that the next stop for the S&P 500 would be 2000.

For fans of Star Trek, it seems as if the S&P 500 is in a tractor beam from the 2000 level and is being drawn toward it. It seems to me as if most of the concerns that were depressing equity prices, in particular military tensions in Ukraine, have been lifted.

EQ: It’s almost like a ping pong ball effect where a major handle attracts prices toward it, but also reflects it back like the rusty door metaphor you’ve used to describe surpassing a key level.

Stovall: That’s right. It’s rare that we would just slice through a major psychological level. Usually we might come up to it, then be repelled a couple of times before we finally break through it. Also, now that this bull market is half way through its sixth year, valuations are looking pretty close to fair value. You also have some pretty well-respected economists such as Robert Shiller talking about how expensive he feels that stocks, bonds, and real estate are. It certainly makes for a tug of war between the bulls and the bears.

EQ: Speaking of valuation levels, in this week’s Sector Watch report, you looked at valuations in the stock market by using P/E ratios for comparison. While the broader market is pretty much in line with historical averages, the sectors are not. In fact, there are three sectors that look considerably undervalued at the moment as compared to their historical average. Why has Technology, Health Care, and Telecom lagged behind the rest of the S&P 500’s other sectors?

Stovall: I think with Technology and Telecom, you’re still experiencing the grossly elevated P/E ratios of the late 1990s. Sector level data only goes back to 1994, so it’s very hard to have those overly inflated numbers not contribute to average relative P/E ratio. At the same time, Telecom is looking very strong from an earnings perspective because Sprint (S) was removed from the index, and as a result, we end up having a sector that is showing earnings increases in the 30%-40% range. So you could say that it is more of a statistical or index anomaly rather than a true growth reading for a particular sector.

What we’re experiencing in Health Care is biotech becoming an even larger component of the sector. Biotech today represents about 18%-19% of the S&P 500’s Health Care sector. At the start of this time series, biotech represented a mid-single digit percentage, if not less. So with earnings growth expectations likely to be very strong as have recent actual numbers, I think that has helped to drive Health Care in terms of price while keeping it looking attractive from a valuations perspective.

EQ: Looking at the S&P 500 being fair value right now, if we do end up getting a correction, it would make it look that much more attractive to investors. That’s not necessarily the case for the SmallCap 600, and the MidCap 400 to a lesser extent. Both are trading at premiums as compared to their historical valuations, and in the case of the SmallCap 600, a bear-market correction would only bring it back to its historical average. Is it possible that we get a major correction in the SmallCaps without it having an effect on the broader S&P 500?

Stovall: That’s a possibility. If we think back to 2011, the S&P 500 did not slip into bear market territory on a closing basis, declining 19.4%, whereas the S&P MidCap 400 and SmallCap 600 declined anywhere from 25% to 28%. So they were certainly well within the range of being called a bear market. There have been many times in which one index ended up falling less than the other indices and did not enter into a new bear market when the other ones did.

EQ: You used the median historical P/E ratios as opposed to the mean. Is this to reduce the effects of the outstretched valuations of past bubbles such as the dot-com and financial crisis?

Stovall: Yes. I didn’t want to make a value judgment of removing particular P/E levels that I felt were unreasonable, so I just let statistics do that for me. By looking at the median, I took the mid-point of all of the numbers since 1994 as compared with a simple average of each of the P/E ratios by quarter going back to the end of 1994.