It’s Tougher to Find Bargains
Thursday, August 15, 2013
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 34.5%, down 5.0 points
  Neutral: 37.3%, up 3.5 points
  Bearish: 28.2%, up 1.5 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

“The market is no longer cheap.” This is how we started our August AAII Dividend Investing newsletter. The S&P 500’s approximate 18% rise in price this year so far has boosted portfolio values, but made life difficult for value investors.

To back our conclusion, I conducted an analysis on the stocks held by the Dow Jones U.S. Index fund (IYY). This ETF owns shares in 1,244 of the largest U.S. companies and a list of the fund’s holdings can easily be downloaded from the iShares website. Thus, the fund gives us a good proxy for determining what median valuations currently are. To ensure an apples-to-apples comparison, I eliminated any companies missing current-year and prior-year price-earnings (P/E) or price-to-book (P/B) ratios. For today’s commentary, I re-calculated the data on the remaining 1,018 companies as of August 9, 2013 to include data from a greater number of second-quarter 2013 earnings reports.

The median price-earnings ratio for this group of stocks is 20.8, versus 16.8 a year ago. The median price-to-book ratio is 2.7, versus 2.3 a year ago. The increases in the two ratios are indicative of multiple expansion. Investors are now willing to pay more for every dollar of earnings or book value than they were a year prior.

Since these are median numbers, they differ from the valuations you will see typically quoted for the market. The S&P 500, the Dow Jones U.S. Index and many other indexes are market-cap weighted, with larger companies having a bigger impact on both the indexes’ price movement and valuations. This is why iShares can list a P/E of 22.3 for IYY (as of July 31, 2013), I can calculate a P/E of 20.8 and both of us can be right. Though a lengthy argument can be made about which measure is better, they’re really just two ways of looking at the same thing. Median stock valuations give insight into what is available for stockpicker to buy, while market-cap weighted valuations give insight into whether the market is cheap or expensive overall.

As to whether you should be concerned about the multiple expansion, Liz Ann Sonders said the answer is no. In a report issued earlier this week, the chief investment strategist for Charles Schwab says the current S&P 500 (market-cap weighted) price-earnings ratio of 17.2 is below the median P/E ratio of 18.7 at which bull markets lasting more than one year have ended. Furthermore, only four out of the prior 13 bull markets ended with a P/E below current levels (1935-1937, 1947-1948, 1949-1956 and 1974-1980), according to the data, dating back to 1928, she used from Bespoke Investment Group.

The current occurrence of prices rising at a time when earnings growth is slowing is also not unusual for bull markets in their third trimester, which Sonders says we currently are in. Rather, she said that this has “been the norm over the past 60 years. We typically see the largest amount of multiple expansion when earnings growth is slowing, not when it’s accelerating, also typical in bull markets' third trimesters.”

None of this guarantees stocks will go higher in the near term; in fact, even Sonders started her commentary by calling the market “vulnerable” to a pullback. What the data does tell you is that higher valuations are not by themselves a reason for worry. They do, however, show the importance of being selective and making sure you are adequately compensated for the risks you incur within your portfolio.

AAII Model Portfolios Updated

For July, the Model Shadow Stock Portfolio gained 6.9%, outperforming the Vanguard Small Cap Index fund (NAESX), which gained 6.7%, but lagging the DFA US Micro Cap Index fund (DFSCX), which was up 7.4%. Year-to-date, the Model Shadow Stock Portfolio has gained 44.4%, beating the Vanguard Small Cap Index fund, which has gained 23.6%, and the DFA US Micro Cap Index fund, which is up 26.2%. The Model Shadow Stock Portfolio has a compound annual return of 18.1% from its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 8.9% annually over the same period.

The Model Fund Portfolio was up 5.2% for July and the newly implemented Conservative Portfolio (75% Model Fund Portfolio and 25% iShares Barclays 1-3 Year Treasury Bond ETF) was up 3.9%. This compares to a 5.5% gain for the Vanguard Total Stock Market Index fund (VTSMX). Year-to-date, the Model Fund Portfolio has now gained 16.6% and the Conservative Portfolio is up 12.3%, compared to 20.3% for the Vanguard Total Stock Market Index fund. The Model Fund Portfolio has a compound annual return of 9.1% from its inception in June of 2003, while the Vanguard Total Stock Market Index fund has gained 8.5% annually over the same time period.

See the AAII Model Portfolios

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The Week Ahead

Second-quarter earnings season will near its end, with fewer than 20 S&P 500 members reporting. Included in this group are Dow Jones industrial average components Home Depot (HD) on Tuesday and Hewlett-Packard (HPQ) on Wednesday. We will also see reports from several retailers throughout the week, including Lowe’s (LOW) and Target (TGT) on Wednesday.

The economic calendar is very light. The minutes from the July Federal Open Market Committee meeting and July existing home sales data will be published on Wednesday. July new home sales data will be published on Friday.

The Treasury Department will auction $16 billion of five-year inflation-protected securities (TIPS) on Thursday.

Dallas Federal Reserve Bank President Richard Fisher will speak publicly on Thursday.

AAII Sentiment Survey

Individual investor optimism fell and pessimism rose to levels not seen since late June, according to the latest AAII Sentiment Survey. Meanwhile, neutral sentiment continued its longest streak of above-average readings since the late 1990s.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 5.0 percentage points to 34.5%. This is a seven-week low. It is the second time in three weeks that bullish sentiment is below its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, rose 3.5 percentage points to 37.3%. This is the 12th consecutive week and the 18th out of the past 21 weeks that neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 1.5 percentage points to 28.2%. This fifth consecutive weekly increase puts pessimism at a seven-week high. Nonetheless, bearish sentiment is below its historical average of 30.5% for the seventh consecutive week and the 12th time in 15 weeks.

The bull-bear spread, which is bullish sentiment minus bearish sentiment, is now at 6.3. This is its narrowest reading since June 26, 2013, when the bull-bear spread was -4.9.

We have not seen neutral sentiment mostly stay above 30.5% for an extended period of time since the late 1990s. During the period of September 4, 1997, through November 4, 1999, neutral sentiment was above 30.5% for 108 out of 114 weeks.

The continued elevated levels of neutral sentiment are indicative of the cautiousness exhibited by individual investors. Though many individual investors are encouraged by earnings growth, the ongoing economic expansion and rising stock prices, many others are concerned about the pace of economic and earnings growth, market valuations and a lack of progress on key issues by Congress and the president.

This week’s special question asked AAII members what they thought the odds of a pullback in stock prices occurring this month or next month were. We specifically asked them to state the odds on a range from very likely to very unlikely. Just over 3% of all respondents described the chances of a pullback occurring as either unlikely or very unlikely. In contrast, 19% said a pullback was very likely, 31% said a pullback was likely and 24% said a pullback was somewhat likely. The top reason was that the market has gotten ahead of itself. The second most commonly given reasons were a potential tapering in bond purchases by the Federal Reserve and a fight in Congress over the budget and the debt ceiling.

Here is a sampling of the responses:

  • “Somewhat likely. The market is very sensitive to the Federal Reserve’s actions and statements.”
  • “Likely. The market needs to consolidate and the slow time of the year should give it a chance.”
  • “Very likely. The market is too high and August and September are usually down months.”
  • “Very likely as Congress deals with debt ceiling issues.”
  • “Somewhat likely. The market has been up all year and some profit taking will likely come in.”

» Take the sentiment survey