Wells Fargo Investment Institute WFC -0.8524341731388521% Wells Fargo & Co. U.S.: NYSE USD52.34 -0.45 -0.8524341731388521% /Date(1502384255465-0500)/ Volume (Delayed 15m) : 5654392 P/E Ratio 12.901477832512315 Market Cap 262046651815.135 Dividend Yield 2.9782359679266897% Rev. per Employee 376971 More quote details and news »
The Dow’s recent breach of 22,000 for the first time in history captured many positive headlines in the financial media. The Wells Fargo Equity Strategy group viewed the event as a reminder that second half headwinds could result in lower index levels at year-end.
The financial media were buzzing last week as the Dow Jones Industrial Average (Dow or DJIA) traded and closed over the 22,000 milestone for the first time in history. Throughout this more than eight-year stock market rally, as each 1,000 point increment in the Dow came and went, there was celebration on Wall Street. (As a point of reference, note that the DJIA hit an intraday bottom just below 6,445 early in March 2009.)
Along the way, we put on our party hats and joined in the festivities as well. We even did some cheerleading. That was because, over the bulk of this recovery, our analysis suggested that the major equity indexes were below what we considered to be “fair value.”
And even though we gauge stocks by looking at the Standard & Poor’s 500 Index, we know that most of the media attention is focused on the DJIA. But our views have changed since early this year. Starting in mid-February, the S&P 500 has been trading above levels we consider to be appropriately aligned with the current and forward-looking fundamentals. Recall that coming into 2016 we were predicting that after multiple years of stocks trading “cheap” relative to their future prospects, we expected the S&P 500 to end the year at or very close to fair value, no matter who was elected president.
In our opinion, getting through last year’s rough and tumble election season finally allowed the S&P 500 to reach that coveted fully valued status. But, as is usually the case, the stock market doesn’t just stop trading when it reaches some magical valuation level. Opportunities are often created in stocks, just like any other market, when they move in a way that doesn’t jibe with the underlying fundamentals. With stocks trading above what we consider fair value, is now one of those opportunities? An opportunity may present itself down the road, but right now the pullback we are expecting is only modest in our opinion. At the time of this writing, the S&P 500 is trading 5.8% above the top end of our year-end 2230-2330 target range. We are not calling for the cycle to come to an end.
We suggest investors stay invested and would consider any 6% to 8% pullback from current levels an opportunity to buy equities. But, in this strategist’s opinion, Dow 22,000 (or S&P 2,475) is an indication that stock market valuations are stretched. Whether you are looking at ratios such as price-to-earnings, price-to-book, or price-to-sales, stocks are trading at the highest levels in at least 10 to 15 years. If the economy and earnings growth were poised to accelerate meaningfully and consistently over the next 18 months, we could make an argument that current market levels are “fair,” but that is not what our analysis suggests.
Modest economic and earnings growth is what we expect with a Federal Reserve that is slowly hiking rates. Can stocks remain meaningfully above or below fair value for extended periods of time? Sure they can; it happens in almost every cycle. But for us, gravity, or fundamentals, will likely prevail in the second half of this year. So while the cycle isn’t over in our opinion, we are not all that excited about Dow 22,000.
— Scott Wren
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