10/21/2017

Are Expectations Getting Too High for the S&P 500 Index?

There are several macro tools AFG provides to help investors stay abreast of trends in the market and successfully identify entry/exit points and the most attractive segments of the market. Tools designed to equip investors to more effectively communicate with clients about times when the market may look overvalued, which metrics are currently delivering the most alpha or which sectors/industries look most attractive in an index at any given time.

One way that we help clients to identify times when the market as a whole is undervalued is via AFG’s Value Expectations interface which essentially solves for the sales growth a company needs to deliver in the future in order to justify its current trading price. By solving for the Implied Sales Growth you can develop a “hurdle rate” for a company relative to what the company has delivered in sales growth historically to understand if a company is likely to meet or exceed expectations. Companies with the highest hurdle rates have proven to be more likely to underperform than companies with realistic expectations for priced-in sales growth.

When you perform this analysis on every company in the S&P 500 you can identify points when the expectations for the entire index approach or move outside of normal ranges (+/-1.5 StdDev) which can signal a point of extreme valuation levels. When the implied sales growth moves outside the -1.5/+1.5 StdDev threshold it signals extreme valuation levels and an opportunity to advise clients to either enter/exit or reduce/increase exposure to a segment of the market.

Currently, (as of 8-31-17) the median company in the S&P500 is priced to grow revenue by around 11% over the next 5 years, while the median company has delivered just 7% revenue growth on average over the past 5 years. This signals that the index is currently has high expectations, however, expectations are still within the normal valuation range.

Similar analyses can be done on any individual company, sector or sub-segment of the market. This helps investors to identify and communicate with clients attractive companies /industries/sectors or to have an objective measurement to discuss strategic entry/exit points with clients.