Pockets of Value in an Expensive Market

Pockets of Value in an Expensive Market

By Jack Forehand, CFA, CFP® (@practicalquant)

The stock market has had a huge run in the past 15 months. As of May 11th, the S&P 500 is now up 64%, off the market bottom, the NASDAQ 100 up 75%, and the Russell 2000 is up an even more impressive 95%. With the big market run we’ve had in the past year, I thought it would be a good time to revisit where we are valuation wise and review the relative valuation of some areas of the market using our market valuation tool.

But before I do that, I wanted to start with a couple of caveats. The first is that market valuation has essentially zero predictive power over short-term market returns. So the fact that the market is expensive (or cheap) tells you nothing about what it will do in the next year. Where valuations can have some predictive power is in providing an indication of the long-term returns we can expect. Above average valuations typically lead to below average long-term future returns and vice versa.

The second caveat is that we use median figures when we look at market valuation. A median is calculated by simply ranking all stocks based on each valuation metric and then selecting the valuation that ranks right in the middle of the distribution. Since our models select from a universe of all stocks, we like to use data that looks at the valuation of the average stock in that universe and how that changes over time. But this type of data offers no value in looking at the valuation of market cap weighted indexes like the S&P 500 or the market as a whole. For those types of indexes, the large companies are much more important to their valuation than the small ones, so median data is not useful.

Now that I got all of that out of the way, here is a look at the median stock’s valuation using the TTM PE Ratio

The valuation has only been more expensive 2.9% of the time since we began tracking this data in 2005. One of the interesting things this data shows is how broad this rally has been. Before the Coronavirus crisis, market cap weighted indexes like the S&P 500 were very expensive, but median data like this didn’t show nearly as much overvaluation since the average stock wasn’t keeping up with the FAANG stocks and the other large companies that dominate the index. That has changed in the past year since this rally has been much broader.

And it isn’t just the TTM PE Ratio. Here is the valuation using the median CAPE

Stocks have only been more expensive about 6% of the time using this metric.

Price/Cash Flow tells a similar story.

And Price/Sales paints the most overvalued picture of them all

Again, none of this says anything about where the market is going in the short-term, but valuations are certainly stretched.

Pockets of “Value”

I have highlighted some metrics in my articles over the past few years that showed that although the market was expensive, value stocks were cheap, primarily on a relative basis, but also on an absolute basis after the Coronavirus crisis. Let’s take a look at whether the recent run has changed that.

On an absolute basis, it definitely has. Here is the median valuation of the cheapest 20% of our universe (what we classify as value) using the TTM PE Ratio

We currently sit in the 58th percentile, so the situation is much better than the market as a whole, but valuations are above average.

The median CAPE paints a more overvalued picture as value is now up to the 81st percentile

Despite value’s move up in absolute valuation, the relative case remains very strong.

After getting to the cheapest level at the market bottom that it has since we have tracked it, value has become a little more expensive on a relative basis, but it remains very cheap.

Using the TTM PE Ratio, it is still in the 5th percentile vs growth.

Using the CAPE it has moved up to the 9th percentile.

As is the case with the overall market data, none of this says anything about what might happen in the short-term, but for investors looking at it from a long-term perspective, value still looks very attractive relative to growth.

If you would like to get more details on this data or run some comparisons yourself, you can access our market valuation tool here.

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.