7/20/20 Market Notes
Equity markets posted solid gains last week on strong corporate earnings, promising coronavirus vaccines news and hopes for additional stimulus. The S&P 500 rose 1.3%, up 4.3% for the month-to-date and 1.0% for the year. Tech stocks finally took a breather last week, with the Nasdaq 100 falling 1.7% but it is still up 4.8% for the month and 22.5% for the year. Investors last week turned their attention to beaten-up value names in the industrial, materials, health care and utilities sectors which all rose +4%. Dividend, small-cap and defensive sectors also performed well.
With the strong recovery in stock prices since March 23, is there any return potential left in US equities? By our calculation, prices are advancing faster than earnings expectations which indicates increasing valuation multiples are driving prices. To assess return potential, we applied the suite of valuation models we use when analyzing individual companies to the S&P 500 Value (SPYV) and S&P 500 Growth (SPYG) indices.
Our valuation models incorporate current price levels and consensus estimates for sales, earnings, free cash flow and dividends and calculate price targets using four valuation models: discounted cash flow (DCF), EBITDA multiples, PE multiples and total shareholder return. Our price target reflects the average of the four models and our expected return is the price target divided by the current valuation, annualized. Results are shown below with data for the S&P 500 (SPY) the average of the two style indices.
Overall, current valuation models indicate potential returns of about 8.3% for the S&P 500 over the next five years, somewhat below longer-term averages. Growth companies have higher expected returns, even after their relative outperformance over the prior twelve months. Value returns still look subdued. We adjusted these expected returns by current leverage levels to risk-adjust the expected returns. Growth looks even better by that measure as it has much lower debt levels than the Value index. DCF shows the highest expected returns and that is due to low cost of capital values and what is perhaps a generous assumption of 3% terminal growth (2.5% for Value, 3.5% for Growth). The multiple models assume 5y valuations equal the average of the prior five years. The TSR model shows the weakest potential returns. That model incorporates revenue growth, EBITDA growth, expected dividend yields, stock repurchases, debt issuance and valuation. Itl shows weak expected returns due primarily to valuations that are currently elevated due to the earnings hit from the current coronavirus recession. Overall, current equity valuations seem to support modest returns over the next several years but do not support much potential return in the short-term. 5y returns can be generated based primarily on expected earnings growth and not on higher future valuations. A more robust recovery would likely lead to increases in consensus earnings forecasts. On the other hand, continued strong price appreciation without a commensurate increase in earnings expectations would leave markets vulnerable to overvaluation. All-in-all, we continue to favor large-cap growth over large-cap value. Growth companies have exhibited more resilience in the current economic environment and generally have strong underlying secular trends supporting growth. Value companies, in contrast, are much more economically sensitive and have much higher debt levels which makes them riskier in a recessionary environment. * Source: Consensus data from Bloomberg; Bruderman Asset Management calculations.
Disclosures: This market commentary is written by the 1879 Advisors® and represents the views of 1879 Advisors®. This commentary is not investment advice and should not be used as a basis to make investment decisions. Please consult with your registered investment advisor before making any investment decisions.