S&P bear case shows median stock above bull-market peaks

New York

IF you're looking for a floor in equities, you may not want to look at research into the valuation of the average US stock authored by Leuthold Weeden Capital Management LLC. The study, published on Wednesday in a note titled How Far Could it Fall, examines a handful of indicators such as trailing price-earnings (P/E) and price-to-book ratios and compares levels now to past inflection points, namely the tops of bull markets and the bottom of bear markets since 1990.

The upshot is that equities have room to fall to get back in line with history. According to Leuthold chief investment officer Doug Ramsey, even after the 8.9 per cent drop in the Standard & Poor's 500 Index (S&P 500) since its May record, the median stock hasn't shrunk enough to match its average valuation at the last five bull-market peaks.

Using blended indicators that also include normalised P/E and price-to-cash flow, getting to a level that matches the market's average valuation since 1957 would take another 13 per cent drop to 1,682. "It shows how extreme median stock valuations got at the peak - that we're not even back to a normal trading window," Mr Ramsey said. "Even after this washout we've had and the underperformance of the average stock relative to the S&P, we're still above the average of the last five peaks."

A report by Minneapolis-based Leuthold predicted in early August that the "next big move in stocks should be down" as breadth weakened amid a 61/2-year bull market. While stocks are unlikely to slip to previous bear market lows that are on average 30 per cent under the S&P 500's current level, Mr Ramsey said it's unlikely in the next year to see corporate earnings grow enough to sustain current share prices.

Claims that stocks are overvalued have been made almost since the start of the bull market in 2009, when the S&P 500 was beginning an advance that restored US$17 trillion to share prices. While easy to ignore as the benchmark gauge returned 20 per cent annualised through July, now they're getting more attention as investors assess damage after the biggest selloff since 2011.

Leuthold's approach differs from conventional valuation techniques in that it considers median stocks rather than the combined P/E of the entire S&P 500, in which companies are weighted according to their market value. An argument against his method would be that size matters when looking at American companies: Should a megacap such as Apple Inc trade at a below-average valuation, that impact should be accounted for.

According to Mr Ramsey, the trailing P/E ratio for the median stock in the S&P 500 is 22.6, about 30 per cent higher than the index's average multiple as a whole. Using five years of earnings data, he gets a normalised P/E for the median stock of 19.9. The S&P 500 fell 1.4 per cent to 1,942.04 on Wednesday.

"Even the 10 per cent pullback didn't shift thinking enough to say it's incredibly cheap and equities look attractive," Greg Woodard, a senior analyst and strategist at Fairport, New York-based Manning & Napier Inc, which oversees about US$46 billion, said. "From the point of view of stocks looking incredibly cheap, we haven't seen that globally since 2009." Bloomberg