Citi analysts Tobias M Levkovich, Lorraine M Schmitt and Christina Wood take a look at the valuation conundrum facing investors in their “Monday Morning Musings – The Valuation Equation” piece dated October 18, 2013.

Investor concerns

  • The S&P 500 (INDEXSP:.INX) has already risen ~20% this year, and earnings are up from 5-6%. Is there anything left on the plate, especially considering a likely Fed tapering next year and a rise in bond yields?
  • Higher bond yields are already being factored in as apparent from the 10-year futures UST chart below, currently ruling at around 5%.

1-ust-yields IT sector

Comfort factors

  • Citi’s intelligence at the ground level (“client surveys, price action and money flows”) shows the lack of any great ‘fear’ among investors.
  • Risk premia are still higher than normal, and markets could push higher if there is unexpected progress on the country’s fiscal issues.
  • The earnings yield gap relative to Baa bond yields shows that the market is positioned near about its 5-year rolling average. When computing the normalized earnings yield gap using 10-year rolling average EPS and the futures market for bonds, the gap, at between 1 and 2 S.D, suggests that there is a 91% chance that the markets would appreciate in the coming year.
  • These factors point that markets have more upside in store for them beyond that stemming from just EPS growth.

IT sector attractive

According to Citi, the IT sector stands out as full of promise considering various valuation approaches. An analysis of the sector using both trailing and forward P/E ratios shows that both are currently at multi-year lows (see graphs below), and in that respect have not kept pace with the multiple expansion witnessed in other sectors.

IT sector

Citi also finds the insurance industry group and the utilities sector attractive based on valuation criteria.