Wall Street set to gain more as valuations stay low

REUTERS

NEW YORK

MAJOR stock indexes have never been higher - and yet that’s hardly scaring people.

Stocks have soared in 2013, with the Dow climbing almost 11 percent to hit a series of new all-time highs while the S&P 500 has jumped 9.4 percent, falling just short of its all-time closing high after rising for 10 of the past 11 weeks. And yet, analysts for the most part see equities as fairly cheap.

The rally has slowed, however.

In the last eight trading sessions, the S&P 500 has managed a daily gain of more than 0.5 percent just once.

Questions remain about the potential impact of US budget negotiations or the Federal Reserve’s plans in continuing its massive monetary stimulus.

The Fed meets next week.

Taken on its own, analysts see potential for more gains in the US stock market, based on metrics like earnings prospects and valuation.

The forward 12-month priceto- earnings ratio for the S&P 500 is currently 13.5, which is about 9 percent less than the October 2007 ratio of 14.8 when the S&P last hit a record.

“This shows that stocks are cheaper than they were at the time of the last high, and at the same time, alternative assets like bonds are much more expensive,” said Paul Zemsky, head of asset allocation at ING Investment Management in New York, who helps oversee $170 billion.

“We are at record levels, but you need to look at stocks in the right context, and in that context, they’re not expensive at all.” The S&P 500’s earnings yield - a reverse of the P/E ratio - currently stands at 7.1 percent, compared with 6.41 percent for the BofA Merrill Lynch US High Yield Index.

That’s an anomaly in the markets - the earnings yield has generally been lower than a benchmark junk-bond yield because it measures the risk of owning the highestquality stocks versus the expected return on the lowest- quality bonds.

The current P/E ratio is also below the historic average of 14.8, according to Thomson Reuters data dating back to 1968. The S&P 500 would need to rise to about 1,647 to become in line with the historic average - about 5.6 percent above current levels, according to Standard & Poor’s.

Interest rates remain near record lows while dividends are growing, another way that stocks are outshining bonds.

In the most recent quarter, the average dividend yield for S&P 500 companies was 2.19 percent, more than the 1.89 percent yield in the fourth quarter of 2007, the period of the last market peak, according to Standard & Poor’s. In 2012, 403 S&P 500 components paid a dividend, the highest number since 1998.

In contrast, the 10-year US Treasury note currently yields 2 percent, so the dividend yield on the S&P 500 would pay more than the bond, without even factoring in potential price growth.

The S&P 500 is also trading well below its intrinsic value, another metric of earnings-based valuation that estimates where a security should trade, based on its expected growth trajectory over the next decade or more.

The index is seen as having a price to intrinsic value ratio of 0.85, according to Thomson Reuters StarMine, which means it would have to rise 15 percent to be in line with its earnings growth trajectory.

More than twothirds of companies are below their intrinsic value, including some of the biggest.

Apple Inc, which has tumbled 16.6 percent this year, is 28.2 percent under its intrinsic value, based on its Friday closing price, while Exxon Mobil Corp is 23.3 percent under and Bank of America Corp is 53.3 percent under its intrinsic value.

Other companies show signs of being overbought.

Google Inc, which has jumped about 15 percent so far this year, is about 16 percent higher than intrinsic valuation. Amazon.com Inc is 85 percent above its intrinsic valuation of $39.17.

“You need to be selective.

While on the whole, we’re in a constructive market supported by dividends and earnings, some companies have probably seen peak levels already,” said John Carey, portfolio manager at Pioneer Investment Management in Boston, which has about $200 billion in assets.

The market’s gains this year have come on accommodative monetary policy from the Federal Reserve and strong corporate results, two factors that investors don’t see going away any time soon.

The Federal Reserve’s interest-rate-setting committee meets next week. Despite calls from some of the board’s more hawkish members to reduce asset purchases, the Fed is expected to continue on its current path.

Recent data - ranging from retail sales and manufacturing to employment - has shown the economy is picking up some momentum. But the high US unemployment rate of 7.7 percent gives the policy committee room to keep buying $85 billion a month in bonds to keep interest rates low.