2014 Predictions

I ended off last year saying that I predicted a stock market crash followed by a short economic recession at the beginning of 2014. So far, I was kind of right.

The year began with the Federal Reserve announcing that it would begin tapering off it's Quantitative Easing Program from $85 billion in monthly US Treasuries/Bonds purchases to $65 billion, as previously predicted. The first three trading sessions (days) of the New Year were red, with the DJI losing hundreds, as also previously predicted. Now, in the middle of January, the stock market is still going down because a lot of companies are missing Earning's estimates, also previously predicted. Citi bank missed earnings and bank mammoths JP Morgan and Goldman Sachs announced bleak futures.

Let's analyze this note written by Goldman Equity Strategist David Kostin

The current valuation of the S&P 500 is lofty by almost any measure, both for the aggregate market as well as the median stock: (1) The P/E ratio; (2) the current P/E expansion cycle; (3) EV/Sales; (4) EV/EBITDA; (5) Free Cash Flow yield; (6) Price/Book as well as the ROE and P/B relationship; and compared with the levels of (6) inflation; (7) nominal 10-year Treasury yields; and (8) real interest rates. Furthermore, the cyclically-adjusted P/E ratio suggests the S&P 500 is currently 30% overvalued in terms of (9) Operating EPS and (10) about 45% overvalued using As Reported earnings.

Reflecting on our recent client visits and conversations, the biggest surprise is how many investors expect the forward P/E multiple to expand to 17x or 18x. For some reason, many market participants believe the P/E multiple has a long-term average of 15x and therefore expansion to 17-18x seems reasonable. But the common perception is wrong. The forward P/E ratio for the S&P 500 during the past 5-year, 10-year, and 35- year periods has averaged 13.2x, 14.1x, and 13.0x, respectively. At 15.9x, the current aggregate forward P/E multiple is high by historical standards.

Most investors are surprised to learn that since 1976 the S&P 500 P/E multiple has only exceeded 17x during the 1997-2000 Tech Bubble and a brief four-month period in 2003-04. Other than those two episodes, the US stock market has never traded at a P/E of 17x or above

P/E: Price to Earnings Ratio --> Share Price / Earnings Per Share. In the context of this note, Kostin is saying that many investors are expecting P/E ratios to grow to 17 - 18 X the current Earnings Per Share, which is very large considering that the ratio for the S&P 500 during the past 5, 10, and 15 year periods has never averaged higher then 14.5%. In fact, the long--term average is supposed to be of 15%. 

Bottom line: Kostin believes that investors have over estimated the growth of the share price which makes them believe the P/E ratio will be 17 - 18X the EPS instead of the current 14X. 

This chart depicts that the P/E ratios have only been this high in the great recession. 

The Current P/E Expansion Cycle Kostin mentions is the economic cycle the P/E goes through during one business cycle (expands then contracts). 

Like this Bear Market Valuation chart from Sitka Pacific Management shows, we should be expecting earnings valuations to contract. The chart shows the average 10 year P/E decline (approximately a cycle, in blue) with the current 10 year P/E decline in red. 

EV/Sales: Enterprise Value to Sales --> Ratio that compares the total value of the company (includes debt and cash) divided by the amount in annual sales. Essentially the total value of the company that is made for every $1 of the company's revenue.

EV/EBITDA: Enterprise Value to Earnings before Interest, Taxes, Depreciation, and Amortization. Another indicator of the value of the company.