S&P 500 fairly valued and small caps rich

The S&P 500 (INDEXSP:.INX) has a 14.3 forward Price over Earnings (P/E) ratio as of September 2013, which compares to a ten year average of 14 and a fifteen year average of 16.3. According to JPMorgan Chase & Co. (NYSE:JPM)’s U.S. Market Strategy Team, the current S&P 500 level of 1,805 as of December 6, 2013 may imply operating earnings between $120 and $130 per share in the next 12 months. One measure that may show overvaluation is the S&P Shiller cyclically adjusted P/E (CAPE) which has increased from 24.3 on September 2013 to 25.41 on December 6, 2013. The 4.6% increase over this period accounts for S&P 500 gains and puts the current level at about 54% over the mean of 16.50 and 34% above the mean of 19.0 calculated since 1950.

S&P 500 Index levels

Source: JPMorgan Asset Management

Large cap growth stocks are about 22% below their 20 year average P/E suggesting price appreciation potential, in JPMorgan Chase & Co. (NYSE:JPM)’s view. Styles that appear overvalued are mid cap and small cap value, which are 1.6% and 2.7% above their 20 year average P/E, respectively. These styles have risen the most in 2013 and some market participants are starting to get concerned over rich valuations.

Current P/E

Source: JPMorgan Asset Management

Earnings per share (EPS) growth has slowed for S&P 500

Even though growth of operating earnings per share continues and total leverage (ratio of total debt to equity) continues to drop, slower growth in EPS is possible. The adjusted after-tax profit as a percentage of GDP is at 10%, which compares to a 50 year average of 6.3%. Furthermore, both margin expansion and revenue growth has slowed in the past two years and may continue to slow in the future.

JPMorgan

Source: Standard and Poor’s, JPMorgan Asset Management

Large caps may be supported by sentiment, favorable value versus bonds, and cash return to shareholders.

Consumer sentiment is at about 80, which is below levels seen at peaks in 2000 and 2007. Investors are optimistic but not overly confident in their outlook. According to JPMorgan Chase & Co. (NYSE:JPM)’s correlation analysis done over 20 years, a 10 point rise in sentiment could expand forward P/E by 2 points.

JPMorgan’s outlook

JPMorgan Chase & Co. (NYSE:JPM) also studied the relationship between weekly stock returns and interest rate movements over a period of 50 years. Results showed that when 10 year Treasury yields are below 5%, rising interest rates are generally associated with rising stock prices. The current 10 year U.S. Treasury yield is at 2.86% (as of December 6, 2013), suggesting possible upside for the next year. This relationship will likely hold, according to JPMorgan’s U.S. Market Strategy team, as GDP growth is accelerating this year relative to the past 2 years.

correlations between weekly stocks

JPMorgan Chase & Co. (NYSE:JPM) analysts also note that S&P 500 earnings yield (inverse of forward P/E) is 7%, which compares favorably to Moody’s Baa yield of 5.4%. The real earnings yield is close to 4%, above its 50 year average of 2.4%, which suggests potential for stock price gains.

real earnings yield

Source: JPMorgan Asset Management

Finally, S&P 500 (INDEXSP:.INX) companies may deploy cash increasing the probability for positive returns. Corporate cash as a percentage of current assets is close to 28% this year, which represents almost twice the level seen in 2000. Shareholders have also benefited from dividend growth and share buybacks since the crisis, and companies may continue to deploy cash to reward shareholders. While capital expenditures have recovered since the crisis, merger and acquisition activity has remained steady since 2010. Businesses may get more confident in doing deals as the economy improves.

cash returned to shareholders

Source: JP Morgan Asset Management