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Should Value Investors Be Getting Nervous?


A look at some of the valuation data on the S&P 500 to see if it there's cause for concern.

The financial news media covers the stock market like it's a race that's run every single day – as if there is a winner and a loser every day. Make no mistake: Every day there are people who lose money and people who make money. But does that make them 'winners' or 'losers'? Those labels feel so harsh.

Could you imagine if your job labeled you a winner or loser at the end of every day based on the success you had that day? That would be quite the emotional swing, wouldn't it?

Your market outlook has to be longer – and committed to creating value that is measured over years, not days, weeks, or even months. Investing is a marathon – and not a series of sprints!

But the mainstream media is spending a lot of energy on a big question: Can this market rally be sustained?

This question comes with all of the ancillary questions: Is it going to continue? Should you get out and take your profits now? How will you feel if you get out and the rally continues? How will you feel if the market gives back all of this gain?

The media tends to focus on these kinds of questions when we see so many up days in one small window. The S&P 500 is up 17% since December 20 – just a little more than 50 trading days. That is quite a nice move.

At my firm, Buy and Hedge, we are long-term investors. We don't ever look to time the market. As former online brokerage executives, we met thousands of clients who spent all of their energy timing the market. While we met a handful that were successful, the overwhelming majority were not. Timing the market is a difficult game.

One thing we know for sure: The market will definitely give back some of these gains. We just don't know when – and we won't try to guess. Might be next month. Might be next year. Could be even later. But we know for sure that it will happen. And that is why we hedge.

But I thought I would at least look at some of the valuation data on the S&P 500 to see if the data showed that we should be getting nervous as value investors. Our sentiment on valuation often drives where we set our hedges – and how much risk we take with our hedges.

I think the data is somewhat encouraging, but needs to be taken with grain of salt. Standard & Poor's tracks and projects earnings for the firms in the S&P 500 index. At the end of December, with the S&P 500 finishing at $1,257, the forward 2012 PE for the Index was 11.77x. The S&P has since rallied by more than 10%. With that move, the 2012 forward PE is now 12.84x. Even if you apply today's price in S&P 500 to the trailing 2011 earnings, the PE would be 14x.

These PE ratios would not be considered 'frothy' by any measurement. Looking back at historical measurements, these are below the mean and median. No one that invests for the long-term should look at these valuation metrics and be concerned that they are buying in to a bubble.

But I mentioned the grain of salt earlier. The grain of salt is the earnings part of the PE equation. Standard and Poor's doesn't always have the best track record of predicting earnings (who does?). S&P expects 10% growth in the EPS for S&P 500 firms in 2012 over 2011. That is a healthy jump. Earnings season hasn't started for 2012 yet, so we don't know if the S&P will be right.

Ultimately, the growth in earnings is based on a recovering US and global economy. These economies are still in a 'tender' state, to put it mildly.

What conclusion can I come to with this limited valuation data? I still want to be long the markets – equities in particular. And I want to be hedged.

Will the markets pull back? Yes – eventually the market will experience a significant trough. It always does. That is why I want to be hedged. I don't know when it will occur so I am always hedged.

Is the market seriously overvalued? Not unless you believe the US and global recovery will both fall flat. And by fall flat, I mean you must believe earnings will tank materially.

Can I be invested in the markets? If you are hedged – yes. Equities still provide the best long-term growth engine for your portfolio.

Remember, it's a marathon. Long-term investors measure success in years – not weeks.

Editor's Note: For more from Wayne Ferbert, go to Buy & Hedge ETF Strategies.
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No positions in stocks mentioned.
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