Warren vs. Yellen. Whom do you believe.
What Buffett Said...
Last week, billionaire investor Warren Buffett mentioned that the stock market would be looked upon as cheap if interest rates would stay as low as they are.
“If these interest rates were to continue for 10 years, stocks would be extremely cheap now,” said the CEO and Chairman of Berkshire Hathaway ($BRK.A) on CNBC’s Squawk Box on Monday, just two days after the annual shareholder meeting held in Omaha.
This is the catalyst's indicator, the basis of the main mover of the market, corporations with M&A, and stock buybacks. With the earnings yield at 5.6%, it exceeds the cost of debt by about 320 basis points, meaning companies can grow by using cash or borrowing to buy growth or engineer it themselves by reducing their float.
This compares favorably with the last peaks in 2007, where the spread was only 107 bpsm or in 2000 where it was actually 340 bps.
Buffett also said that if interest rates were to normalize, stocks would be on the higher side on a valuation basis.
If bond yields increased 2-3% to 5% on long-term government bonds and nearly 7% on corporates, this would be negated. If we look at P/E ratios isolated from all other data, the S&P 500 trades at 18 times versus an historical average of 16 times.
And he also said that bonds are very overvalued and stocks are the cheaper of the two.
What Yellen Said...
Federal Reserve Chair Janet Yellen recently described stock market valuations as high and said the central bank was carefully monitoring their impact on financial stability.
"I would highlight that equity market valuations at this point generally are quite high," Yellen said in conversation with Christine Lagarde, Managing Director of the International Monetary Fund, at an economics conference.
Again, looking at the metric of P/E ratios in a fish bowl, we are at a 15% premium based on operating earnings. It should be noted that the S&P 500 traded at 18 times in 1992, prior to an historical run of over 300%.
Risk of Declining EPS growth in 2015
Some pundits point to negative EPS growth. S&P 500 EPS are expected to decline 1.3% this quarter and end 2015 with a flattish 1% increase. However, adjusted for oil and currency effects, likely to be one-year events, S&P 500 EPS are up a healthy 7-8%.
On a PEG ratio (P/E to growth rate) basis, S&P earnings still look to be on the right side of cheap at a PEG of only 2.20 times, compared to a longer-term average of 2.58. Looking at small-cap stocks, the Russell 2000 trailing P/E, ex negative earnings, were 23.3 times for the quater ending on March 31, 2015 versus. a five-year EPS growth rate of 13.73%, implying a PEG of 1.70 times.
U.S. Equities Lagging Selected Global Markets
Global markets in Russia, China and Europe are vastly outperforming U.S. equities so far this year. Low valuations and stimulative monitary policies are proving to hard to resist for many asset allocators. Currencies have also held back growth in the US.
"But there are potential dangers there," Yellen said.
The very-low level for short-term and long-term interest rates represented a risk because rates can move rapidly, she explained.
However, the Fed's actions at home are still stimulative.
Our excess liquidity indicator is bullish at 400 bps. This means the Fed is providing 4% more liquidity than the current nominal GDP growth rate. This figure takes into account the decreased velocity of money in recent periods. We arrive at this figure by subtracting the annual percent change in velocity from the year-over-year percent change in M2 money supply. Then we subtract the most recent quarter’s percent change in GDP. Q1 came in at 0.2, and granted a winter pass based on a tough winter again this year.
Yellen warned that "valuation metrics" for "smaller caps and biotechnology industries" —aka startups—"appear substantially stretched."
Small-cap stocks, as judged by comparing the T. Rowe Price New Horizons Fund (PRNHX) to the S&P 500 are not cheap, at a 1.81 times ratio. However, they look a lot cheaper if we substitute the P/E of the Russell 2000 (1.31 times) or the equal-weighted Russell 2000 ETF (1.01 times).
Reminiscent of Greenspan's 1996 call of irrational exuberance ahead of a 100% plus advance in most market indexes to the year 2000, past and present Fed heads have a less-than-stellar track record on calling markets.
We know whose side we will take: the self-made $74 billionaire who has reaped from his investment acumen.
Our valuation indicators side with Warren. Our fair-value target for the S&P 500 is 2687, representing a 27.5% upside from the close on March 27th. The target uses a 22.5 times multiple applied to 2015’s estimated operating earnings of $119.30.
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