A Less-Bearish View of the Market

When pundits talk about whether the market is cheap or expensive, they usually use some kind of top-down measure, looking at aggregate statistics about the market or the economy. My bearish colleague Curt Morrison has discussed some of these--the Q ratio and the normalized price/earnings ratio--at length in a series of recent articles, and others have reached similar conclusions using different top-down tools.

Rarely, however, does anyone attempt to value the market in a bottom-up fashion, looking at each stock individually and then summing the results. Moreover, those that do tend to base their analyses on multiples of accounting earnings rather than using a discounted cash-flow (DCF) approach, which is closer to economic reality. We favor a DCF approach because it accounts for companies' cost of capital and capital-spending needs, and because cash flow is less subject to distortion than accounting earnings. It's not a perfect tool--nothing is--but we think it's the best one out there.

Is the Market Cheap or Expensive?
For the past several months, we've posted a chart showing the median ratio of price to fair value of our coverage universe on Morningstar.com. As the number of stocks we cover has expanded from around 500 a year ago to more than 1,500 today, our coverage universe has become a better approximation of the entire stock market. Over that same time, the median stock we cover has varied from being slightly undervalued this past August to being about 14% overvalued today.

Directionally, that's a similar conclusion to that of those who argue that the market would need to fall by 40%-50% to be fairly valued, but there's a big difference in magnitude, to say the least. Since aggregate statistics rarely tell the whole story, let's tear apart Morningstar's coverage universe a bit to see what's really going on--and whether we're really in for a bear market of historic proportions or not.

Valuing the S&P 500
Most of the top-down measures that claim the market is egregiously overvalued use the S&P 500 as their proxy for "the market." This is understandable, since many researchers have spent a great deal of time constructing reasonably accurate data series for the S&P 500 going back many years. It's also defensible, since the S&P 500 represents about three-quarters of the value of all U.S. equities, and many money managers use it as a benchmark

However, there is one important characteristic of the S&P 500 that limits its usefulness as a barometer of the entire market--it's weighted by the market capitalization of the stocks within it, which means that its performance (and valuation) is tied closely to a relatively small number of companies. For example, the largest 10 companies in the S&P make up about 22% of its total value, and the largest 100 comprise over two thirds of the index. So, if these few companies are quite cheap or quite expensive, any conclusions about "the market" based solely on the valuation of the S&P 500 will be flawed.

Nonetheless, the S&P is as useful a starting point as any, and since it's the market proxy most often used by bears, we can at least make an apples-to-apples comparison. Morningstar covers 476 stocks in the index, which represent 98.9% of its value, so our bottom-up DCF valuation of the S&P 500 is pretty comprehensive.

When I sum up our fair value estimates and weight them by market cap, I get a value of 1,160 for the index, which means that it's about 4% overvalued according to our fair value estimates. On an equal-weighted basis, the average S&P 500 stock is about 8% overvalued. Again, these estimates are directionally in the same camp as the bears, but the differences in magnitude are striking.

Value Right Under the Market's Nose
What's going on here? Most top-down views of the S&P 500 peg it as very overvalued, while our bottom-up analysis of the same index concludes that it's either within shouting distance of fair value or mildly overvalued.

The following table tells part of the tale:

 Valuing the S&P 500: Big Is Cheaper, Small Is Pricier
Stocks	% of index	% under/overvalued (average)
Largest 10	21.7	-5.5
Largest 25	36.3	-3.2
Largest 100	66.0	6.6
Largest 250	86.5	10.7
Smallest 250	12.5	19.0

According to our DCF-based estimates of fair value, it looks like the larger the stock, the cheaper it is, which is why a capitalization-weighted view of the market looks different from an equal-weighted view. This fits well with my own anecdotal evidence that many of the mega-cap stocks that led the market to wild heights in the late 90s are now reasonably priced, or even inexpensive.

Five of the S&P 500's 10 largest companies have had a 5-star Morningstar Rating for stocks within the past few months-- Microsoft (MSFT),  Wal-Mart (WMT),  Pfizer (PFE),  Johnson & Johnson (JNJ), and  American International Group  (AIG)--and three of those would only need to pull back by 5% or less to be 5-star stocks again. Essentially, what's happened is that a lot of large caps have been increasing their free cash flow faster than their shares have appreciated over the past few years. As a result, the shares have gotten a good deal cheaper, even though they never took the 50% haircut experienced by many tech companies when the Nasdaq bubble burst.

For example,  Coke's (KO) shares are down more than 20% over the past five years, even though free cash flow has increased by 80%. Another 5-star stock,  Medtronic (MDT), shows a similar story--though its shares have risen about 30% over the past five years, free cash flow has more than tripled.  Paychex (PAYX), which is currently 5 stars, and Johnson & Johnson, which was 5 stars until the stock ran up recently, show similar patterns of free cash flow growth markedly outstripping share-price appreciation.

Run for the Hills or Back Up the Truck?
So, now we have a sense of why the S&P 500 looks like it's pretty close to fair value despite the median stock in Morningstar's coverage universe being about 14% overvalued--big companies look more attractive than many smaller companies at the moment. But there's still a big gulf between the bottom-up conclusion (the market's fairly valued or mildly overvalued) and the top-down conclusion (buy a fallout shelter). Without getting into a dull point-by-point discussion of the bear case, let me at least offer some food for thought.

Most top-down analyses posit that some valuation metric--the Q ratio or a normalized P/E ratio, for example--will revert to some long-run mean. However, these theories don't address why the market must mean-revert--they simply note that it always has happened, and therefore will again at some point. Personally, I find this unsatisfying. Financial markets have changed quite a bit in the past 20 years (for better and for worse), and I think that attempting to value something as dynamic as the stock market from a purely historical viewpoint ignores more than a few issues.

For example, one could argue that the cost of capital--both equity and debt--is lower for firms now than it has been for most of the past 120 years. Interest rates are low, and financial markets are more liquid, which one would think is worth something when investors are mentally calculating their personal hurdle rates. One could also argue (more persuasively, I think) that returns on incremental capital are higher now than they were 40 or 50 years ago. The U.S. economy is less capital-intensive today, which means that today's "E" was likely generated with a lot less capital than the manufacturing-driven "E" of past decades. Assuming similar growth rates and risk profiles, it seems entirely logical to me for investors to pay a higher price for an earnings stream that requires less capital reinvestment.

Buy Stocks, not Markets
Of course, the bottom-up approach has its own warts. Historical studies of Wall Street earnings estimates have shown that sell-side analysts are persistently too optimistic in their forecasts. While some of this optimism stems from the sell-side's well-known conflicts of interest, some likely stems from the overconfidence bias that's been well documented in behavioral finance studies. While the fair value estimates made by Morningstar's analysts are free from the former problem, the latter is unfortunately human nature.

Also, the bottom-up approach explicitly assumes a continuing--or "perpetuity"--value for all companies, when the reality is that many companies that look fine today will be bankrupt or irrelevant 10 or 20 years from now. I think we do better than most shops on this front, since we currently peg the fair value of about a dozen companies at zero, but there's still probably an upward bias in our bottom-up estimates. Perpetuity is a long time, after all, and a lot can happen.

As with most things, I suspect the truth lies somewhere in the middle. My personal guess is that the S&P's fair value is closer to 1,160 than 625, but I have little trouble accepting the general premise that market returns over the next several years may very well be lackluster. (When Jack Bogle of Vanguard, Bob Rodriguez of FPA, and Warren Buffett all agree on something, it's hard to ignore it.)

However, the market is a big place, and one can do just fine buying and holding stocks for $0.70 on the dollar even if the major indices don't do very much. In fact, I'd argue that time spent analyzing companies and deciding which ones fall within your own circle of competence is likely to be a more productive exercise than attempting to value the market. After all, unless you own nothing but index funds--or actively managed funds that are closet indexers--your portfolio's returns will likely be affected more by which stocks you own than by what the S&P 500 does over the next several years.

Etc.
In case you were wondering, I also applied our DCF-based fair values to a couple of other popular indices. Our bottom-up fair value for the Dow is about 10,860, which means we think it's essentially fairly valued. The Nasdaq 100, however, looks pricey--our bottom-up fair value is about 1,380, which means we think it's overvalued by about 16%.