The S&P 500 was in the red Monday morning as Microsoft shares slumped, weighing on the index and the Dow Jones Industrial Average following the news that the company has struck a deal to acquire LinkedIn. It seems that every time the index flirts with a record high, it pulls back, so the debate about what it will take to beat the high set more than a year ago rages on.

Fair value for the S&P 500?

It’s been difficult to understand why investors were pushing U.S. equities higher and higher amid mixed economic data and a lack of strength in revenue and earnings performance. However, the gap between non-GAAP and GAAP earnings has begun to improve, and Bank of America Merrill Lynch strategists believe the worst is behind us.

Savita Subramanian and team said early Friday that U.S. stocks were expensive compared to history as the index’s forward price to earnings ratio expanded to 17 times last month, which was 10% higher than its long-term average.

S&P 500

They added that multiples were still high compared to history looking at most metrics, including the GAAP price to earnings ratio, which sat at 24 times. That was almost 30% higher than its average and the highest level since 2009.

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S&P 500 struck by uncertainty

The S&P 500 crashed on Friday after BAML strategists issued their report titled “S&P 500 P/E on GAAP earnings is at a cycle high.” The extreme volatility in the index is a symptom of a lack of conviction on U.S. stocks. Economic uncertainty remains high as the markets wait anxiously for the Brexit referendum, and the U.S. Federal Reserve can’t seem to decide what to do about interest rates. Hawkish comments made last month quickly evaporated following the May jobs report, which showed a significant disappointment in the number of jobs added during the month.

Investor money poured out of stocks on Friday and into U.S. Treasuries and other defensive investments. On Monday, gold priced reached their highest level in four weeks as the U.S. dollar and British pound struggled.

Earnings quality improving

One good thing, the BAML team pointed out last week is that the GAAP gap is improving. They said asset write-downs and impairments related to commodities and charges related to acquisitions, especially within the Healthcare sector, have been driving the gap between GAAP and pro forma earnings per share. However, oil prices have climbed by over 90% from their lows, and the merger and acquisition cycle is slowing (although today’s news about Microsoft’s acquisition of LinkedIn is huge).

Subramanian and team report that this is the first time in two years that the GAAP gap has started to narrow, and consensus estimates for S&P 500 earnings suggest that it will continue to narrow for the rest of the year. They add that as this gap narrows, the GAAP price to earnings ratio should slowly near alignment with the pro forma price to earnings ratio, just as it did in 2009 and 2002.

Valuations gap among S&P 500 sectors remains wide

The BAML team adds that although the S&P 500 as a whole is expensive relative to history there is still a great dispersion in industry valuations. On the inexpensive side are the Technology and Financials sectors. Semiconductors, Communications Equipment, Electronic Equipment Instruments and Components, Internet Software and Services, Capital Markets, Consumer Finance, Banks, and Insurance are all trading lower than their long-term metrics, they explained.

The BAML team said Food and Staples retailing was one “inexpensive industry” within Staples, while Healthcare and Pharma look cheap a well. They said Materials and Energy are the “most attractive” of the sectors in the S&P 500, as momentum and revision ranks are strong within them even though the valuations aren’t great. They add that Utilities and Staples were the two worst-ranking sectors again for a second month in a row.

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