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Question of the Week - January 30, 2017

Question of the Week - January 30, 2017

Guest Post - Monday, January 30, 2017

Are equities getting expensive yet?

They certainly aren't as cheap as they were a few years ago, but valuations tend to be relative, and are based on the metric used.

From a price ratio perspective, valuations have moved richer, mostly because recent price appreciation has hinged on the expectation of fundamental underlying earnings improvement this year (this is always how it works...if you wait for earnings to register better results first, you'll often miss the rally). From a dividend discount model standpoint, which is dependent on growth of future earnings and dividends (as well as other semi-theoretical variables, as well as the implied discount rate and dividend payout ratio), valuations look more reasonable, at a few percentage points above fair value. Of course, such models are heavily dependent on the quality of the inputs used.

When you begin to compare different assets classes to each other, the issue gets more nuanced. The classic 'Fed Model', for example, compares stocks to bonds by either inverting the standard price/earnings ratio into an 'earnings yield' (or the reverse, as some folks invert the bond yield into a 'P/E' but the result is the same). In this case, even if equity P/E's are quoted at 20, that converts to a 'yield' of 5%, which compares more cheaply to the current ~2.5% yield for the 10-year treasury. This metric is undoubtedly rough, but is a classic back-of-the-envelope method for determining attractiveness, based on the underlying fundamental point of purchasing securities in the first place—actual earnings. Asset allocators often use this technique as one form of valuing real estate and other assets where a payout exists. Obviously, assets with no payout are harder to value using such a fundamental method, like growth stocks and commodities.

The commonly watched Dow Jones Industrial Average finally reached the magical 20,000 level. Of course, this particular point and the Dow index itself are not widely followed by professionals, but big milestones like this tend to make mainstream news. One impact is that, for investors who have been on the sidelines waiting for a 'better' time to finally invest, these types of high profile events often spur them to finally participate. This is one of the likely reasons for the famed momentum effect that has been so persistent in a variety of asset classes, yet so difficult for academics to explain, as it's no doubt tied in to human behavioral tendencies to follow the herd, chase winners and other phenomena. On the positive side, such momentum can perpetuate already existing market trends.

What's the conclusion? It's a mixed message for 'value' investors, since these folks tend to prefer market bottoms and dire conditions for ideal entry points. We're obviously beyond this point. However, 'momentum' folks rely on trends of market strength for investment opportunity, which can often be self-fulfilling as more investors jump on for the ride. Based on this perspective, equity conditions could continue to be favorable, as long as expectations are kept in check.

Read our Weekly Review for January 30, 2017.

Read the previous Question of the Week for December 27, 2016.

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