Determining if the S&P 500 is overvalued
In another article, we discuss smart rebalancing. An important element of smart rebalancing is understanding whether the markets you’re adding or subtracting to are under, over, or fairly valued. For example, let’s say your equity component is invested in the S&P 500 index. If the index started the year at 700 and was 30% undervalued (fair value was 1000) but went up by 10%, it would still be undervalued by 23% (700 plus 10% is 770). Would you want to rebalance by selling some of the equity that’s still significantly undervalued and move those funds to a fixed income market that was still overvalued?
So, the $100M question is how can you determine the fair valuation of a market. As you would expect, there are many ways. Here’s one of the metrics we use:
3 Year Trailing Operating Income / Enterprise Value Yield.
Many of the conventional valuation metrics are based on Net Income. We prefer Operating Income (Op Inc) as it’s more reflective of the underlying business (as it excludes non-operating events like investment gains and interest expenses). Below is a table showing Operating Income and Net Income for the S&P 500 for the last 5 years.
The Operating Income is less volatile than the Net Income. We use the average of the previous 3 years to smooth out some of the bumps.
We prefer Enterprise value for the denominator as it takes into account the cash the companies have on hand and the long-term debt that they carry.
Below is a chart showing the 3 Year trailing Operating Earnings Yield and the yield on BBB bonds (as calculated by the Federal Reserve).
Over the 25 year period shown in this chart, the average 3 Year Trailing Operating Income Yield was 6.40%. The BBB Yield was 5.91%. They’re both risk assets and they generally move in line.
Historically, when the Earnings Yield of the S&P 500 is higher than the yield of BBB-rated bonds (BBB Yield), then the S&P 500 is undervalued. In our opinion, the greater the difference between these two yields (the “spread”), the more undervalued the S&P 500 is. Conversely, when the Earnings Yield of the S&P 500 is lower than the BBB Yield, the S&P 500 is overvalued. And again, the larger the spread, the greater the degree of overvaluation for the S&P 500.
For instance, if we examine the period between 1998 and the first half of 2021, the indicator above has produced the following results:
- On days when the BBB Yield was lower than the 3 Year Operating Income, the 2 year forward annualized return of the S&P was a little over 11%.
- On days when the BBB Yield was higher, the 2 year forward annualized return was less than 1%.
The larger the spread, the more pronounced the forward 2 year return. We use this metric and a few other similar ones to measure the relative valuation of the S&P 500 (and other indices we follow)
