Equal-Weighting S&P 500
July 12, 2015
Timing of IRA Contributions
The popular market-proxy S&P 500® index is market-cap weighted. This is one of the factors that helps reduce the turnover of ETFs tracking this index. For example, the iShares Core S&P 500 ETF (IVV) has a turnover rate of only 4%. The following chart, produced by the Alpholio™ App for Android, shows the characteristics of a portfolio composed solely of this ETF:
(Note that Alpholio™ uses a broader ETF as a representation of “the market”; hence, the beta of IVV is different from the conventional one and alpha from zero.)
However, market-cap weighting implies that the largest companies’ stocks have the highest impact on the index. While returns of mega-caps in the index tend to be less volatile, they are usually lower than those of their smaller-cap peers. To overcome this limitation, other ETFs weight equities in the index differently. For example, the Guggenheim S&P 500™ Equal Weight ETF (RSP) assigns each of the 500 stocks a 0.2% weight. This tilts RSP toward smaller-cap equities in the index and results in a 18% turnover. Over the same analysis period, RSP produced markedly higher returns than IVV but at the expense of an elevated volatility and a slightly lower Sharpe ratio:
In addition to overweighting of mega-caps, some economic sectors in the index dominate others, as shown in the latest edition of S&P Capital IQ The Outlook:
To counteract this, the ALPS Equal Sector Weight ETF (EQL) applies the same weight to nine sectors (with telecommunication services considered part of information technology). Here are the characteristics of a portfolio consisting solely of this ETF over the identical analysis period:
While the annualized return of EQL was lower than than of IVV or RSP, it was more than adequately offset by a decrease in volatility, which resulted in an improved Sharpe ratio and maximum drawdown.
What if the investor wanted to equal-weight all ten sectors instead of just nine, i.e. keep telecoms separate from IT? To do so, the investor could construct a portfolio of Vanguard sector ETFs, excluding the Vanguard REIT ETF (VNQ). That is because real estate stocks are currently part of the financials sector and not expected to become a separate asset class until mid-2016. Here is how such a portfolio, rebalanced quarterly (just like EQL), performed over the same analysis period:
The Vanguard sector portfolio had the second highest alpha and Sharpe ratio as well as the second lowest standard deviation (a measure of volatility of returns).
The above analysis period was dictated by the inception date of the EQL, the youngest of all the ETFs used. Arguably, this approximately six-year period may be considered too short and not representative of performance over a full economic cycle. However, it was interesting to see that while equal-weighting the index on a security level produced highest absolute returns, equal-weighting on a sector-level delivered the highest risk-adjusted returns.
To conduct your own analyses of various ETF portfolios, download the Alpholio™ app from
January 21, 2014
Inflation- and Dividend-Adjusted Market Peaks
With the start of a new calendar year, many investors are considering making 2014 contributions to their individual retirement accounts (IRAs). However, given the recent appreciation of stocks to the perceived point of overvaluation, and poor prospects for bonds in light of an anticipated rise in interest rates, many investors may hesitate to make early contributions. This brings about two questions: What is the historical penalty for such procrastination? What happens if the investor decides to spread the annual contribution over time in the allowable period?
A simplistic answer to the first question is given in an article in The Wall Street Journal:
Contributing $5,500 to an individual retirement account each January, rather than in April of the following year, over 31 years (with an average annual 7% return) could boost the IRA balance by $55,000.
This calculation assumes a constant rate of return on investment in each year, which is unrealistic. In addition, it assumes that the contribution is fixed at a currently allowed maximum amount, even though in recent years the maximum has been revised upwards to approximate inflation (granted, historical maximum contribution was fixed at $2,000 between 1981 and 2001). Also, it does not specify the percentage increase of the terminal balance. Finally, it does not specify the exact nature of the “moderate” portfolio in the IRA.
To provide a more accurate answer to both questions, Alpholio™ conducted a mini study. (Since this post is longer than a usual one, time-pressed or impatient readers may want to skim the charts and navigate right to conclusions at the end of this write-up.)
To make study results tangible, instead of pure indices, two low-cost, no-transaction-fee investment vehicles with sufficiently long life spans were chosen: the Vanguard 500 Index Fund Investor Shares (VFINX) and Vanguard Total Bond Market Index Fund Investor Shares (VBMFX) mutual funds. The younger of the two, VBMFX, determined the longest feasible study period beginning in January 1987. For both funds, total (i.e. with reinvested distributions) rather than just price returns were used.
Various IRA portfolios, ranging from 100% stocks (all-VFINX), to 60% stocks and 40% bonds (the “standard” portfolio), to 100% bonds (all-VBMFX) were investigated. All portfolios were rebalanced monthly to their nominal asset allocations. Instead of a fixed contribution, a maximum contribution allowed by law in each historical year was assumed. The study did not take into account the higher “catch-up” contributions allowed for older investors, or any withdrawals or mandatory distributions that could trigger taxes or penalties.
The study considered two scenarios. In the lump-sum scenario, the maximum allowable contribution was made in whole at the beginning of a single month ranging from January of the contribution year to the following April (the deadline for making a contribution for the prior calendar year typically falls in mid-April). In the dollar-cost averaging (or “spread”) scenario, the contribution was evenly split and made at the beginning of a number of months starting in January of the contribution year.
The type of scenario determined the terminal year of investment. In the lump-sum scenario, the terminal investment could be made from January 2012 to April 2013 (that is because as of this writing, monthly data through April 2014 are not yet available). To roughly time-align with the lump-sum scenario, the spread investment scenario assumed that the terminal investment would take place in 2012.
For all asset allocations, the penalty was calculated as one minus the ratio of the terminal value of the portfolio with delayed or spread investments to the value of the portfolio when all investments were made as early as possible in January (baseline). For example, if delayed or spread investments resulted in a terminal portfolio value of $93,000 and January lump-sum investments generated $100,000, then the penalty was 1 – 93/100 = 7%.
The Lump-Sum Scenario
As could be expected, due to generally positive returns of stocks and bonds over time, a delayed lump-sum investment carried a penalty. Here is the penalty for a 100% stock and 0% bond (100/0) portfolio:
Generally, the lump-sum penalty had a positive relationship with the investment delay — the longer investor waited, the bigger the shortfall of the terminal value of the portfolio. However, the penalty did not always grow monotonically with the delay, as can be seen by its significant decrease in November and December in the above chart.
This particular case underscores the impact of first years of investing. Here, the almost 22% negative stock market return in October 1987, followed by a negative 8% return in November 1987, caused the penalty to diminish if the investor delayed the contribution toward the end of that year. To further illustrate the importance of early contributions in the IRA life cycle: The $2,000 invested in January 1987 was worth over $27,000, or about 10% of the terminal value portfolio, at the end of 2013.
The trend line in the chart shows that on average a procrastinating investor suffered a penalty of 0.66% of the terminal portfolio value per month of delay, culminating in about 12% of penalty if all investments were made in April of the year following the contribution year.
The more the IRA portfolio tilted towards bonds, the smaller the penalty. Here is a chart for a standard portfolio:
With this asset allocation, the penalty reached just over 10% and accrued at 0.63% per month.
For a 40% stock and 60% bond portfolio, the maximum penalty was just below 10% and grew at an average rate of 0.60% per month:
Finally, for a bond-only portfolio, the penalty peaked at just over 7.5% and increased by 0.52% per month on average:
According to the article:
An analysis of traditional and Roth IRA contributions made by Vanguard Group customers for the 2007 through 2012 tax years showed that, on average, 41% of the dollars contributed to IRAs for any given tax year are invested between January and April of the following year. Half of those dollars are contributed in the first half of April—the final weeks when contributions for the previous year can be made. The study found only 10% of dollars are contributed in January of the corresponding tax year, the earliest month contributions can be made.
This means that the majority of investors pay a significant price for delaying their investments. Granted, many investors may find it hard to come up with a lump sum for the entire contribution each January. Others may want to spread their investment over two or more months to minimize the risk in fluctuating market conditions. Let’s take a look at the effects of the latter scenario next.
The Spread Scenario
For a stock-only portfolio, uniformly dividing the annual contribution carried an average penalty of 0.53% per each additional spread month. When the contribution was dollar-cost averaged over the entire year, the total penalty was just over 5.5%:
For a standard portfolio, the penalty accrued at 0.41% per additional spread month to reach almost 4.5%:
For a more conservative 40% stock and 60% bond portfolio, the penalty increased on average by 0.34% per month and peaked at almost 4%:
Finally, for a bond-only portfolio, the penalty rose by 0.22% per spread month to reach a maximum of just over 2.5%:
The above findings are consistent with those of a Vanguard study on outcomes of lump-sum and dollar-cost averaging of investments. That study used fixed 10-year intervals, sliding by one month in a longer period of 1926 to 2011. It found out that for a standard portfolio, in 67% of cases a lump-sum investment outperformed dollar-cost averaging over the first 12 months of each 10-year interval. The terminal value of the lump-sum portfolio was on average 2.3% higher than that of the dollar-cost averaging portfolio.
Not surprisingly, delaying or spreading IRA contributions within the allowable 16-month window for each contribution year resulted in a penalty of a lower terminal value of the portfolio. The per-month average accrual rate and the magnitude of the penalty depended on asset allocation in the portfolio: The more tilt toward equities, the higher the rate and magnitude. Contributions in early years had a dominant impact on penalty distribution due to compounding of returns.
Clearly, investors pay a substantial price for procrastination in a lump-sum contribution scenario. Therefore, the investment for a given contribution year should generally be made as soon as possible. However, in many cases a full contribution amount may not be available early in the year, the investor may be averse to taking the risk of a lump-sum investment in given market conditions, or may not have a complete view of his/her income and tax situation until later in the contribution time frame. In that case, dollar-cost averaging with smaller sums can help lower the risk of a one-time investment and penalty for a delayed contribution.
December 26, 2013
Turn-of-the-Year Market Trends
With a strong performance of equities in 2013, major market indices have reached peak levels. In an attempt at accuracy, many articles in the financial media adjust index values for inflation. The conclusion is that the market, as measured by the Dow Jones Industrial Average (DJIA), has surpassed record levels from early 2000 only very recently on an inflation-adjusted basis. On the other hand, a broader market benchmark, the S&P 500® index, is still about 15% below its inflation-adjusted 2000 peak. Having suffered significant downturns in both 2000 and 2008, the NASDAQ-100 index is significantly below both its nominal and inflation-adjusted historical highs.
The problem is that in all of these assessments, a price level of each index is used. Would the findings be different if indices were also adjusted for reinvested dividends to account for total returns? To determine that, Alpholio™ compiled inflation- and dividend-adjusted prices of two representative exchange-traded funds: the SPDR® Dow Jones® Industrial Average ETF (DIA) and SPDR® S&P 500® ETF (SPY). These ETFs are long-lasting and popular implementations of their respective indices. To adjust for inflation, the Consumer Price Index – All Urban Consumers (CPI-U) was used.
A conventional price chart shows that DIA has indeed just matched an inflation-adjusted record high from January 2000:
However, a chart for DIA with reinvested dividends indicates that the previous inflation-adjusted peak from October 2007 was already surpassed in mid-January 2013:
Similarly, a price-only chart illustrates that SPY is still about 13% below its inflation-adjusted top from March 2000:
On the other hand, the chart with dividends factored in demonstrates that SPY already exceeded the previous inflation-adjusted maximum level in May 2013:
According to S&P Capital IQ, since the late 1920s dividends constituted about 45% of the total return of the stock market. Therefore, any assessment of the current market level has to adjust not only for inflation but also for reinvested dividends. From that standpoint, historical market peaks were quietly surpassed much earlier this year. Time and again, media focus is on generating simplified headlines rather than noting true events.
December 17, 2013
Year-End Market Predictions
‘Tis the season for the usual pondering of the turn-of-the-year market trends. A report from the Merrill Lynch Equity and Quantitative Strategy team shows that January has statistically delivered the highest monthly returns and second-highest (after December) frequency of positive returns in all months:
In contrast, a blog post in The Wall Street Journal demonstrates that the December rally is more pronounced and consistent across observation timeframes than the January one, which vanished in the last 20 years:
However, from a monthly peak-close perspective, December is unremarkable, as an article in The Wall Street Journal illustrates:
This finding is less meaningful because it only determines the magnitude of monthly oscillation, rather than a complete return in each month.
According to the post, an interesting return pattern emerges in the last and first month of the year:
A pullback in the middle of December is caused by tax-loss selling by traders, window dressing by fund managers, and portfolio realigning by investors. Once this is over, a rally ensues. However, according to the article, it is statistically significant only in a short period at the turn of the year:
There is one version of the Santa Claus rally that enjoys strong historical support: the last five trading sessions of December and first two of January… Since the Dow was created in 1896, it has gained an average of 1.7% during this seven-trading session period, rising 77% of the time. That is far better than the 0.2% average gain of all other seven-trading-session periods of the calendar.
Here is how the S&P 500® returns look so far this December, as compiled by Alpholio™:
Despite a pullback early in the month, there is some similarity to the above long-term average return pattern. Of course, only time will tell if the rest of the pattern is followed.
The seasonal effects are mostly pronounced in small-cap stocks. In addition, the report claims that lower-quality stocks strongly outperform in January:
Loading up on “junk” equities for the sake of a superior one-month return is probably not advisable. If anything, this might be an opportune time to tilt the portfolio towards high-quality, cash-rich companies, which Merrill Lynch itself recommends in its 2014 outlook. Seasonal market trends, such as the Santa Claus rally or January effect, no matter how likely, should not cloud a long-term investment perspective.
December 12, 2013
At year’s end, many analysts make market predictions for the next twelve months. The S&P 500® index is a popular target for such forecasts since it is commonly used as a market proxy and its constituent stocks are widely followed. Hence the bottom-up analysis — a sum of estimates for all individual equities makes an index forecast.
Who better to predict the S&P 500® index level than the S&P itself? Let’s take a closer look at their forecast accuracy. The following chart compares the predicted to actual values of the index, which Alpholio™ compiled from historical editions of S&P Capital IQ’s The Outlook:
To be exact, these 12-month targets were typically set in early to mid December of the preceding year, while the actual index values were recorded on the last trading day of the predicted year. Also, dividends were not taken into account in this price index.
The immediate takeaway from this chart is that the forecast for 2008 vastly overestimated the actual price: 1,650 vs. 903, or by about 83%! The financial crisis and its magnitude caught everyone, including members of the S&P Capital IQ’s Investment Policy Committee, by surprise. Excluding that outlier year, here are the index prediction and annual return statistics:
||Prediction vs. Actual
||Actual Index Return
The sample is admittedly small, under ten data points. But a trend is emerging — on average, S&P predictions underestimated the actual index. This tendency is further illustrated by the following chart from FactSet’s Targets & Ratings report:
The chart shows how a bottom-up target price (dashed line) moved almost in parallel with the actual index (solid line) in the 12 months through October. In other words, predictions were adjusted upwards with a lag as it became evident that original estimates were likely going to be soon surpassed. (As a side observation, almost half the stocks in the S&P 500® were rated a Buy, slightly less than half a Hold, and only about 5% a Sell. Even a booming market, a less optimistic distribution would be intuitively expected.)
S&P offers another interesting prediction for the next year:
We also believe 2014 could be one of those years in which the S&P 500 is up for the entire year but suffers through a pullback of 5%-10% (and more likely a correction of 10%-20%) before ending the year higher than where it started. One reason is that 26 months have elapsed without the S&P 500 slipping into a correction, versus the average of 18 months (and median of 12 months) between declines of 10% or more since 1945.
If statistically the market is overdue for a correction, let’s also hope that by the same token S&P underestimated the 500® index’s value in 12 months from now. In that case, we should be expecting a price of about 1930 instead of the current target of 1895, while keeping in mind that perfect market predictions are virtually impossible.
November 29, 2013
Return of Irrational Exuberance
As the end of the year approaches, the investment industry is gearing up for the annual portfolio rebalancing act. An article in InvestmentNews gives the following example:
Still, advisers’ plan to stick to their long-term asset allocation was likely thrown out of whack this year by the divergence of stocks and bonds. For example, a client who started the year with a simple 60/40 portfolio comprised of the $287 billion Vanguard Total Stock Market Fund (VTSMX) and the $247 billion Pimco Total Return Fund (PTTAX), the two largest mutual funds in the world, would now have 66.3% invested in stocks and just 33.7% invested in bonds, pushing beyond the typical 5% leeway most advisers give their asset allocation.
To illustrate the divergence from asset allocation historical averages, here is a chart from a Vanguard blog post:
While the collective allocation of mutual funds and ETFs to equities has recently reached 57%, the biggest divergence from the historical median is in international equities. Allocation to bonds is also relatively high, while the proportion in domestic equities is close to the 20-year median.
The higher allocations to international equities and bonds are at the expense of cash. Assets in money market funds are at a historical minimum of about 18% in the observation period. This has undoubtedly been caused by the low interest rate policy of the Fed, which depressed returns of such funds. The danger is that when interest rates eventually rise, bond prices will suffer:
So in an intermediate-term bond fund, with an average duration of four to five years, the loss would be about 4% to 5%.
This means that it may actually be prudent for an average investor to shorten the duration by moving a part of investment in bonds to money market funds.
Historically, the proportion of international equities in the total equity allocation has been about 19%; currently, it is about 27%. The argument for keeping it high is a relatively low valuation of foreign stocks compared to domestic ones:
When rebalancing portfolios, it is also important that investors understand the true exposure of their mutual fund holdings to various asset classes. The recurring problem, which Alpholio™ addressed in several prior posts, is that managers in some equity funds (especially value strategies) hold a large percentage of assets in cash. As a result, asset allocation in the overall portfolio can be distorted unbeknownst to the investor.
Alpholio™ provides current information on the exposure of mutual funds to various asset classes. This information is not obtained from the regulatory filings or selective disclosures of fund holdings, which suffer from a number of problems.
In sum, when rebalancing a portfolio either on a fixed schedule or as a result of divergence from prior allocations, investors should take into account a broader market and interest rate context, rather than just follow rigid rules.
November 23, 2013
High Stakes in Small Caps
A host of industry articles have recently raised an alarm about a possible return of irrational exuberance in the stock market, much like the one at the end of the 1990s. Bloomberg reports that investors have poured the most money into stock funds in 13 years:
Stock funds won $172 billion in the year’s first 10 months, the largest amount since they got $272 billion in all of 2000, according to Morningstar Inc. (MORN) estimates. Even with most of the cash going to international funds, domestic equity deposits are the highest since 2004.
In addition, investors currently have a high proportion of stocks in their portfolios:
The market run-up has left investors as a group with an unusually high allocation to equities, at 57 percent. Equity allocations were higher only twice in the past 20 years: in the late 1990s leading up to the technology stock crash of 2000, and prior to the 2007-2009 global financial crisis.
The most often quoted signal of overvaluation is Robert Shiller’s cyclically-adjusted price-to-earnings ratio (CAPE).
The numerator of the ratio is the real value of the S&P 500® index, i.e. a nominal value adjusted for inflation by the consumer price index (CPI). The purpose of this adjustment is to bring the value of the index to an equivalent present level. Assuming a rising CPI, i.e. inflation as opposed to deflation, historical values of the index are adjusted upwards. The intuition for this adjustment is that the nominal return of the index can be modeled as a sum of the real return and inflation. In the presence of inflation, the real return is smaller than the nominal one, hence a higher adjusted historical value of the index.
Similarly, the denominator of the ratio is a 10-year average of real trailing earnings of the index. A longer-term average removes the effects of market cycles. Nominal historical earnings are adjusted for inflation the same way as the index value.
The result is that, as reported by a Wall Street Journal article, the current CAPE of 25.2 is well above its historical average of 16.5:
Most industry articles therefore conclude that the market is in a bubble (although perhaps not as bad as in early 2000 when the CAPE was approximately twice as high). However, as the chart shows, the CAPE is currently still well inside the “yellow zone” and not in the “red zone” of 28.8 or higher.
Moreover, the current CAPE value in the chart is just an estimate. As of this writing, the actual data used to calculate the metric are incomplete. The most recent trailing four months of earnings (July through October) are missing and thus their adjusted counterparts are not included in the historical average. The November CPI is estimated from the values of just two previous months that indicated deflation.
When the missing earnings are estimated from the previous 12-month trend, the CAPE comes out closer to 24.8. The current 10-year earnings average starts in November 2003 when real profits were just rebounding from the nadir in March 2002. Therefore, in the next few years the denominator of CAPE should get larger. It is also worth noting that even with the current incomplete data, the CAPE was as high as 23.5 in February 2011, which at that time did not seem to raise many concerns.
In an interview with BusinessInsider in January 2013, Shiller stated the following:
John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams, showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price earnings ratio. And that had a pretty good fit. So I think the bottom line that we were giving – and maybe we didn’t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism, it doesn’t tell you – and I had the same mistake in my mind, to some extent. Wait until it goes all the way down to a P/E of 7, or something.
…the lesson there is that if you combine that with a good market diversification algorithm, the important thing is that you never get completely in or completely out of stocks. The lower CAPE is, as it gradually gets lower, you gradually move more and more in. So taking that lesson now, CAPE is high, but it’s not super high. I think it looks like stocks should be a substantial part of a portfolio.
I think predicting something like 4 percent real for the stock market, as opposed to 7 or 8 percent historically.
So, the CAPE should not be used as a timing mechanism but rather as an estimator of the future 10-year real returns. Even with the market reaching new highs, perhaps some rational exuberance is due after all.
November 12, 2013
Are Stocks Overvalued?
A trio of articles covers high year-to-date returns, valuations and, consequently, increased risk of small-cap equities, especially those with growth characteristics and in the technology sector.
An article in Bloomberg indicates that the rise of small-cap stocks has historically signaled an economic improvement:
Shares of companies … in the Russell 2000 Index (RTY) have advanced 32 percent in 2013, compared with 19 percent for the Dow Jones Industrial Average. The spread is the widest for any year since 2003, according to data compiled by Bloomberg. Three of the last four times small-caps outperformed by this much, the economy grew faster the next year and stocks stayed in a bull market for another year or more, based on data from the past 34 years.
While small-cap earnings are growing fast, valuation of these stocks has also increased:
Russell 2000 companies are beating analyst earnings estimates by 11 percent, more than twice the rate for companies in the Dow, according to data compiled by Bloomberg.
The Russell 2000’s price-earnings ratio increased 52 percent this year to 27.5 times estimated operating earnings, compared with 14.7 for the Dow, according to data compiled by Bloomberg.
The first article of the two from The Wall Street Journal brings up an issue of high stakes in the technology sector in many small-cap growth mutual funds:
The second article in The Wall Street Journal worries about small-cap returns:
Small-capitalization growth funds are up an average of 33.1% in 2013 through October, according to Morningstar Inc. That compares with average gains of 28.7% for small-cap value funds and 26.3% for large-cap growth funds. Within the small-cap growth category, many funds have gains approaching, or even topping, 40%.
However, the article states several factors propelling small-cap stocks:
- A more direct exposure to the U.S. economy compared to large-cap stocks (per the Bloomberg article, 84% of an average Russell 2000 company sales vs. only 55% of an average DJIA company are domestic)
- A higher rate of organic earnings growth thanks to profit reinvestment
- A continuing low interest rate policy of the Federal Reserve that encourages investors to seek higher returns in riskier assets.
So, have investors been compensated for the increased risk of small-cap stocks? One way to determine that is to compare historical Sharpe Ratios of small-cap ETFs to those of the S&P 500® ETF (all figures to October 31, 2013 from Morningstar):
The above data show that small-cap growth stocks have indeed provided higher risk-adjusted returns than large-cap equities did. However, the same cannot be said about the broader small-cap sector or its value component in the last three- and five-year periods.
August 18, 2013
According to an article in The Wall Street Journal, stocks are currently overvalued. First, the author compares the price-to-earnings (P/E) ratio of the S&P 500® index based on reported (i.e. net income) trailing twelve month (TTM) earnings to a 140-year median value. Then, the author admits that forward-looking, i.e. next twelve month (NTM), earnings estimates predict operating income that is higher than the net income, which suppresses the P/E ratio. To overcome this discrepancy, the author extends the average relation of the NTM P/E being lower than the TTM P/E by 24%, as observed from 1976 to 2003, to the entire 140-year historical period. (The 24% discount encompasses three factors: the predicted growth of earnings from TTM to NTM, difference between operating and reported earnings, and over-optimism in earnings forecasts.) This sleight of hand enables the author to conclude that in either case, stocks are currently overvalued by about 25% compared to a historical P/E median.
This mixing of reported and operating earnings, coupled with an arbitrary extension of a medium-term observation to a very-long-term historical period, leads to dubious conclusions.
Here is an alternative point of view from the July 22, 2013 edition of the S&P The Outlook:
From a fundamental perspective, S&P 500 valuations continue to look attractive. As of July 12, the S&P 500 is trading at 15.9 times trailing 12-month operating results, including the June 2013 EPS results projected by Capital IQ consensus estimates. This multiple represents an 11% discount to the median P/E of 17.8 times since Wall Street started looking at operating results in 1988. What’s more, the market is trading at a multiple of 15.2 times and 13.7 times trailing 12-month operating EPS for year-end 2013 and 2014 results, respectively.
Why does S&P look at operating results instead of reported earnings? Because of distortions caused by large, non-recurring, non-cash expenditures, and also by time misalignment of reported tax expenses with actual tax payments. Indeed, as the article’s title suggests, P/E ratios aren’t always what they seem.