Deciding Whether or Not Stock Valuations Have Peaked

by ETFguide | December 8, 2012 12:46 am

“I don’t need a friend who changes when I change and who nods when I nod; my shadow does that much better”.

Plutarch’s muse hints at the root of advice executive coaches provide that, “challenging your boss or a friend is often wanted and encouraged”, that is if they are indeed to be admired and worthy of such discussions.

This 2000 year old quote by Plutarch also warns of the dangers of group think and the herding mentality that often exists (such as on Wall Street and elsewhere in the mainstream).  To really be a friend, tell me when I am wrong or misinformed, don’t just stand idly by and contribute to my failure.

GroupThinking

Wall Street Strategists are in the process of releasing their 2013 market expectations which inevitably include a 2013 market (NYSE:SPY[1]) projected growth rate.  What do you think it will be?

Here’s a hint: In 2010 they suggested the market would rise around 10% and in 2011 the consensus was a rise of about 10%.  In 2012 the median strategist assumed a growth rate of 10%.  What do you think they are expecting for 2013?

10% it is!  This of course has more to do with sticking to the historical average than it does sticking a neck out to make a call.

It is also no coincidence that Wall Street Analyst consensus “Hold” ratings on stocks such as ExxonMobil (NYSE:XOM[2]) and McDonald’s (NYSE:MCD[3]) are at an all time high of 67% (analyst “holds” were under 30% in the year 2000).  The amount of “sells” still hovers around only 5%, since I guess pretty much all companies are still (as always) great to own.

Groupthink at its finest.

The Multiple Problem

The bigger problem here is that the groupthink can only go on for so long before logic, math, and evidence make the prevailing argument ever more difficult.  Wall Street has that problem now with their constant arguments for continued stock multiple expansion (or even the maintenance of it).

Recently, the controversial Jim Cramer endorsed Starbuck’s (NASDAQ:SBUX[4]) and justified it partly because it is trading below its historical multiple.  “Starbucks sells for 23.8 times next year’s earnings estimates,” Cramer said.  “That’s below the company’s five-year average historical multiple of 28.2 times earnings, and it’s also a major discount to other high-growth food chains.”

The problem with Cramer’s flawed reasoning is that multiples across all stocks have actually fallen even though they have had one very huge tailwind. But unfortunately, the tailwind is starting to blow softer and softer and will eventually reverse, becoming a headwind on prices.

Back to School – Valuation Fundamentals

The spreadsheet below is a very simplistic, yet meaningful, example of the financial model called the discounted cash flow which is used in many shapes and forms all through the finance world.  It is used extensively in the valuation of stocks and helps explain why valuations and multiples are much nearer their highs than their lows, the reason being discount rates are very near their all time lows, and realistically can’t go much lower.

A discount rate of 6% yields a stock valued at $510 based on this example.  Do you know what simple (and inevitable) event will cause the discount rate to increase and thus the prices and multiples to fall?  Here is a hint, it has been a positive tailwind for stocks since 1981.

 Deciding Whether or Not Stock Valuations Have Peaked

In our October ETF Profit Strategy Newsletter we identified 12 MegaThemes that help readers to cut through the noise and successfully navigate the markets (NYSE:IVV[5]).  

One of our mega themes is that stock valuations are closer to their peak than their ultimate low. For that reason, we are warning subscribers. “Discount rates (NYSE:TLT[6]) are at all time lows.  Discount rates will rise and multiples will contract.” 

When discounts rise and multiples contract, guess what happens? Share prices also contract.

In an upcoming issue of the ETF Profit Strategy Newsletter we will dive into stock valuations and the key factor that will significantly change over the next few years driving multiples down.  Don’t give into the groupthink and conflicted interests of Wall Street. It’s better to use logic and evidence based decision making to drive your long term investment decisions.


Endnotes:
  1. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  2. XOM: http://studio-5.financialcontent.com/investplace/quote?Symbol=XOM
  3. MCD: http://studio-5.financialcontent.com/investplace/quote?Symbol=MCD
  4. SBUX: http://studio-5.financialcontent.com/investplace/quote?Symbol=SBUX
  5. IVV: http://studio-5.financialcontent.com/investplace/quote?Symbol=IVV
  6. TLT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TLT

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