Investors are still Euphoric, and there is a good chance of a correction this year, but the S&P 500 is only slightly overvalued according to Citi’s most recent PULSE report.
“Our Panic/Euphoria model remained in Euphoria territory, while our proprietary Cyclical Expectations Model bounced higher. One of our highly correlated valuation metrics argues that the S&P 500 (INDEXSP:.INX) is roughly 20% undervalued, but several other measures are less attractive,” writes Citi analyst Tobias Levkovich.
This Euphoria reading is slightly lower than last week, dropping from 0.58 to 0.55, but it still gives an 83% historical probability of a downward correction in the next year. While most people have expected the market to drop, as its currently doing, no one seems very convinced that the losses will stick.
S&P 500 modestly overvalued at 16.3x; investors cautious
The normalized earnings yield gap fell slightly, now 1.25 standard deviations below the long-term average, which suggests the S&P 500 is somewhat overvalued. Doing the same analysis with Baa bonds instead of Treasuries gives a difference of 0.16 standard deviations below the historical mean, implying the market is fairly valued right now. The S&P 500 is currently rated at 16.3x P/E based on trailing four quarter operating EPS, which certainly isn’t cheap but many people think is justified.
Equity funds had $6.41 billion inflows for the week ending January 22, with domestic funds gaining $2.45 billion and foreign funds gaining $3.96 billion, while bond funds had $247 million in outflows. At least some of those inflows were capital being redirected from emerging market bonds and equities that investors worry will take a hit as tapering accelerates.
Citi holds S&P 500 year-end estimate
“Better hiring intentions are encouraging, plus stock buyback activity has stepped up and money has begun to flow into equity funds. With a 1,975 S&P 500 target by year-end 2014 as economic conditions improve this year, we remain generally constructive longer term while continuing to advise nearer-term tactical caution,” writes Levkovich.
He still warns investors to be cautious in the near term, because the market could fall further before he expects it to start growing again, but he is bullish for 2014 overall. Emerging market weakness, forex volatility, and the impacts of tapering are downside risks while improving housing and employment data, the possibility of more M&A deals, and upbeat earnings guidance are upside risks right now.