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A Fundamental Correction

Many investors are looking at their portfolios and they continue to question whether a top is near. A good number of analysts were expecting some sort of correction towards the middle of this year and have yet to see that prediction really come to fruition.

We did experience a slightly greater than 5% correction in the S&P 500 during the May and June time period, but many are still wondering where that 10+% correction is. Since the May and June correction, the market has advanced 8.9%.

So, the crystal ball question that everyone has is what really is a fair value for these markets heading into the last five months of the year? One thing to remember is that this question pertains to the ultra-short term and over the longer term it is best to not time the market, rather trust its long term trend.

But looking at the near term, many could likely argue that the markets are, from a fundamental standpoint, slightly overvalued. Looking back over the past four years (the post market bottom cycle), we see an S&P 500 that has an average price to book of 2.16x, an average price to cash flow of 8.06x and an average price to earnings of 15.36x.

One way to look at valuation of markets or individual investments is to look at the growth rates needed to rationalize a current valuation. And from here one can look at historical trends/averages to determine the likelihood of the investment hitting these growth numbers. One benefit of this is that we are able to manage the assumptions that are made when analyzing.

By looking at the averages of the before-mentioned fundamental ratios over the past four years, we determined that earnings would need to be 7.03% higher, book value would need to be 16.07% higher and cash flow would need to be 17.67% higher to support an S&P 500 at 1708.

Thus, we would need to see these underlying data points advance at these levels over the next year in order to just support our current levels today, based on the four year averages of our fundamental indicators.

Earnings have seen an average growth rate of 15% over the past four years, but this average drops considerably when expanded over 10 years; it drops to 8.18%. Book value has only see an average growth rate of 7.3% over the past four years and just 6.9% over the past 10 years, while cash flow has only advanced 6.31% over the past four years and 7.20% over the past 10 years. We would need to see cash flow from operations per share of approximately $211/share to justify an S&P 500 at 1708, based on the four year average price to cash flow of 8.06x.

Now, the argument could be made that looking over longer periods of times (10 or 20+ years) that the current levels show the markets are more fairly valued than overvalued. But looking at the most recent market cycle, a 10% correction seems justified. And an S&P 500 that gets back to the levels of 1540-1555 would seem like a great opportunity to enter into equities for another jump higher.

(All data used within The Capital Course was provided by Ned Davis Research)


 

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