(MENAFN- Khaleej Times) It is ironic that the 30 per cent rise in the American stock market last year was due to a rise in valuation multiples and the impact of corporate shares buybacks since earnings growth was a mediocre four per cent. This means Wall Street equities are now skating on thin valuation ice, with the median large cap stock on the S&P500 index now trading at 17 times earnings. Is it realistic to expect another year of multiple expansion? Absolutely not. Higher interest rates will increase the cost of share repurchase programme funded by cheap corporate debt issuance
I believe the consensus estimate of $122 index earnings on the S&P 500 is too optimistic and Shiller ratios/price to book metrics for the S&P 500 show compelling evidence of irrational exuberance. A world in which Amazon.com trades at near 600 times earnings, where IPO mania has swept Wall Street and Chinese Internet shares rule the roost tells me the animal spirits of capital markets have begun to underprice risk. I prefer to buy fear and sell greed but Mr. Market is forcing me to do the opposite
The S&P500 last traded at 18 times earnings in the early stages of the 1999-2000 Silicon Valley tech bubble or in the depths of the early 1990's recession when earnings were gutted by the Gulf war and the New York banking/property/LBO crises. Sure, stratospheric valuations are goosed by the lowest interest rates in generations but the ten year US Treasury bond yield has now doubled from its 1.39% historic low. Valuations on Wall Street have historically been correlated with higher margins, which cannot rise if the US dollar is in a secular uptrend since almost 40% of the S&P 500 index companies derive their earnings from outside the United States. If inflation shocks/wage rises hit corporate America, margins, EPS growth and valuations will all decline
While an accelerating US economy boosts sentiments on profits, it also reawakens the inflation phobic bond vigilantes of Chicago who could force a "behind the curve" Yellen Fed to do a monetary policy U-turn and scale up its taper, a scenario not remotely priced into US equities. A Chinese credit crunch/Lehman moment or the election of the anti-euro, anti-IMF populist right wing parties in the European Parliament could result in another global run on Club Med debt. This means the chances of a stock market correction on Wall Street are unacceptably high in my risk/reward calculus. Ideally, I would like to accumulate the US stock market if the S&P 500 falls to 1650. Will it? Watch earnings season, China, the Fed, Washington fiscal policies and the Chicago Volatility Index (VIX)
The 12 per cent fall in the Canadian dollar, low interest rates and distressed valuations in mining could mean Toronto/TSX could be an index winner in 2014. There are also tangible areas of undervaluation in emerging markets such as South Korea, whose valuation multiple now is not much higher than it was at the nadir of the post-Lehman equities free fall. Is the secular bull market that began in 2009 (the Obama bull?) over? Not at all. I still believe DM equities will be the best performing major asset class in the world in 2014, as they were in 2013
However, multiple valuation on the index is now iffy and the quest for alpha will require opportunistic stock picking, (e.g. the Ford trade). This does not mean there will be no 100 point fall in the S&P 500 index this spring. In fact, this is exactly what I expect to happen. This means positioning for index and sector post correction entry points is critical to make money in Wall Street equities
My favourite sectors are autos, software, biotechnology, regional banks and oil services. As usual, there will winners and losers in each sector, the ballast for profitable strategy and single stock ideas
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