Day Hagan Research Update




Valuation measures may not be good timing indicators, but they are a good measure of upside/downside potential.


Neil Leeson


December 8, 2016


By most historical valuation measures, the stocks that make up the S&P 500 composite index are overvalued. But like any longer-term indicator, valuations can and will overshoot to the upside and the downside. As shown below, one indicator that is at extreme levels (nearly +3 standard deviations) is the median price to sales ratio of S&P 500 stocks. This ratio values every dollar of a company’s sales. In this example, investors are paying $2.39 for every $1 of sales. Historically, investors have typically paid less than $1 for $1 worth of sales. If you look at earnings, book or dividend measures, you’ll get a similar message, although not quite as extreme.

S&P 500 Index vs. 5&P 500 Median Price/Sales Ration Chart

While the U.S. market is near or at valuation extremes, global equity markets based on the cyclically adjusted P/E (price to earnings) ratio range from fairly-valued to undervalued. The U.S. market represents over 50% of this index, but unlike the S&P 500 index, it includes small- and mid-capitalization stocks.

MSCI All Country World Cyclically-Adjusted Read Price/Earnings Ratio

If we use the same cyclically adjusted ratio for the U.S., valuations are elevated, but don’t seem so ominous.

MSCI U.S. Cyclically-Adjusted Real Price Earnings Ratio

On a forward earnings basis, several U.S. sectors have reached valuation extremes. The energy sector is trading at a 42x forward P/E, suggesting that equity prices within the sector have run too far too fast. If used as a sentiment indicator, it would suggest that investors are extremely optimistic on energy stocks going into 2017.

U.S. Sectors & Industries: Price to Forward Earnings: Energy Sector

On the oposite end of the sector valuation picture are financial sector stocks, which are trading at a forward P/E of 12.5x. While not extreme, expectations for future growth are high. Currently the S&P 500 is trading at a forward P/E of 17x. There are seven sectors above and four sectors below this measure. Suggesting earnings expectations are also elevated on a sector basis.

U.S. Sectors & Industries: Price to Forward Earning: Financial Sector


While there may be elevated valuation risks in the U.S. market and sectors, several global markets are trading well below their historical median P/E. While undervaluation can persist for long periods, it does provide a starting point for us to evaluate global markets that may have upside potential with limited downside risk.

Through our international ETF exposure, we have exposure to Chinese equities. As shown below, based on the MSCI China index and comparable P/Es, Chinese equities are trading well below the median P/E.

Interestingly, of the 45 countries that make up the MSCI World Index, only six countries are trading above their historical median P/E. And sixteen global equity markets have P/Es one standard deviation or more below their historical median P/E. Confirming that on a global basis, we have not reached historical valuation extremes.

MSCI China Cyclically-Adjusted Real Price/Earnings Ration

The most undervalued markets—Columbia, Malaysia, Israel, and South Africa—are all represented in small portions through our exposure to emerging market and Asian ETFs. Unfortunately, to gain more exposure to these markets would require more country-specific and currency risk than we are willing to take at this time.

Nonetheless, there are larger markets, like China, that remain attractive from a valuation standpoint. Singapore is one example where undervaluation may present opportunities down the road.

MSCI Singapore Cyclically-Adjusted Real Price/Earnings Ratio

However, our biggest concern remains the underlying trend in home currency versus the U.S. dollar as outlined in last week’s publication. In general, we want the international currency working for us (strengthening) when allocating to dollar-based international ETFs. The Singaporean dollar has improved lately and is supporting the ETF. But the overall trend remains down, which has hurt the fund’s performance this year (below).

Singapore’s GDP growth has been somewhat sluggish at 2.7%, but remains well above other developed economies in the region. Real estate stocks make up nearly 19% of EWS, which stand to benefit from government policies designed to increase spending on social housing. Additionally, the ETF’s exposure to industrials consumer stocks will benefit from new government spending on health care services and infrastructure projects.

EWS Currency Exposure Indicator

In sum, while valuations are certainly more attractive globally than they are in the U.S., our enthusiasim for dollar-based international ETFs remains cautious given dollar strength. However, it is our view that the strength of the dollar has reached its limits and further upside from here may be limited.

Have a wonderful week,

Neil Leeson
Day Hagan Investment Committee Consultant
Day Hagan Asset Management

Written 12.08.2016

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