The S&P 500's prolific 12% year-to-date gain is something to be admired, given the talk of the town was recession-centric at the turn of the year. However, the past is the past, and with the index due to rebalance this month, the question becomes: Is the S&P 500 still undervalued after its latest surge?
Let us delve into a deeper discussion to find out.
Headline valuation metrics
A broad range of metrics must be observed to determine whether the S&P 500 is undervalued, overvalued or fairly valued. And arguably, the simplest of them all is the Fed Model, which uses the reciprocal of the 10-year U.S. Treasury yield as a justified price-earnings ratio. In other words, if the S&P 500's actual price-earnings ratio is below the justified ratio, it can be safely concluded that the index is undervalued.
Based on the current 10-year yield and the Fed Model, the S&P 500 deserves a price-earnings ratio of approximately 26.47, which is above the index's trailing ratio of 24.49. Therefore, the Fed Model indicates that the S&P 500 is in undervalued territory.
Another model that can be used to value the S&P 500 is Edward Yardeni's seminal valuation model, which is simply called "The Yardeni Model". Yardeni's formula uses the Fed Model as a baseline but considers corporate earnings.
As a rule of thumb, if the index's forward earnings yield exceeds the 10-year Treasury yield, the S&P 500 is in an investible territory. Based on Yardeni's latest data, the trajectory of the two constituents suggests the index is undervalued and investable.
Source: Yardeni
A final valuation metric to consider is Shiller's CAPE, which gives a parsimonious indication of the S&P 500's current valuation versus its average inflation-adjusted valuation. The metric aggregates the index's 10-year average earnings per share ratio and adjusts its current price-earnings accordingly to discover a relative comparison.
According to GuruFocus' data, the current CAPE ratio of 29.9 shows the S&P 500 is overvalued on an inflation-adjusted basis.
Based on salient valuation metrics, the S&P 500's trajectory is indeterminate as Shiller's CAPE contradicts the outputs of the Fed and Yardeni Models. Although the Fed and Yardeni models indicate the S&P 500 is undervalued, Shiller's CAPE suggests the index's average earnings per share is inflated by inflation instead of embedded growth.
Fundamental and technical analysis
Traditionally speaking, investors opt to invest in stocks when interest rates are low and drift toward cash investments once interest rates are above their moving averages, which is why the S&P 500 shed value in 2022 when interest rates rose sharply.
Despite the interest rate argument, the year-to-date rise in the S&P 500 is most likely due to a technical correction after last year's sell-off. Therefore, the question now becomes: Is it time to start looking at interest rates again, or will technicals prevail?
Let us examine both to garner an optimal understanding.
Based on the rhetoric from economists, the Federal Reserve's recent behavior and headline inflation rates, it is unlikely that volatile interest rate activity will surface anytime soon. The reason for this is the core inflation rate has officially dipped below 5%, lending policymakers to gradually increase and decrease interest rates until inflation reverts to the 2% to 3% region. Thus, the interest rate environment suggests the S&P 500 will likely be flat for the remainder of the year.
Source: U.S. Bureau of Labor Statistics
Lastly, a counterargument exists within a technical analysis of the S&P 500 based on the relative strength index. The RSI measures the magnitude of buyers versus sellers over a given time horizon, and an RSI above 70 suggests an asset is overbought. In contrast, anything below implies that an asset has room to run. This suggests, as displayed by the chart below, the S&P 500 might be set for a retracement in the short term; however, solid price momentum over the medium to longer term is possible.
Source: Barchart
Wall Street's take
The story from Wall Street is unclear. In fact, there is a fair argument that the debate on Wall Street has been left in a stalemate as there is no linearity of opinions from leading equity analysts.
To illustrate the claim above, outlooks from Goldman Sachs (NYSE:GS) and Morgan Staley (NYSE:MS) can be juxtaposed.
The prior is bullish on the S&P 500, with analyst David Kostin stating the index might reach 4,500 by the end of the year. According to Kostin, "GS Economics assigns a 25% probability of recession in the next 12 months, compared with 65% for consensus. The P/E multiple of 19x is greater than we expected, led by a few mega-cap stocks. But prior episodes of sharply narrowing breadth have been followed by a 'catch-up' from a broader valuation re-rating."
In contrast to Goldman Sachs' Kostin, Morgan Stanley analyst Mike Wilson believes the S&P 500 will revert to 3,900.
"The boom/bust period that began in 2020 is currently in the bust part of the earnings cycle a dynamic that we believe has yet to be priced during the bear market that began 18 months ago and has been largely related to just higher interest rates," he said. "In other words, margins and earnings will decline rapidly as inflation falls so be careful what you wish for."
As illustrated, leading analysts on Wall Street are not singing from the same hymn sheet, suggesting the S&P 500's destiny might yet be indeterminate until more clarity about the interest rate cycle and corporate earnings surfaces.
Final word
Salient qualitative and quantitative indicators imply the S&P 500's destiny for the remainder of 2023 is indeterminate as seminal valuation models, fundamental analysis, technical analysis and opinions on Wall Street remain juxtaposed.
Until more clarity about the interest rate cycle surfaces, it is improbable that the S&P 500's outlook will be linear among analysts. Therefore, the risk-return profile of the index is in unfavorable territory.
This article first appeared on GuruFocus.
