What the Market Wants: Where are Valuations Now?

March 31, 2014

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Courtesy of David Brown, Sabrient Systems and Gradient Analytics

Today’s market was strong with lots of volume to open the week and close the quarter. The strongest index of the day was the Russell 2000, up 1.8%, followed by the S&P 500, up 0.8%, and the NASDAQ, up 0.7%. NYSE volume was a strong 810 million. The S&P 500 squeaked out a narrow 0.7% gain for the month, which is better than the NASDAQ’s 2.5% drop and the Russell 2000’s 1% drop. The biotechnology ETF, IBB, delivered an exceptionally strong performance, up 3.1% for the day after a dreadful month. The quarter was led by the S&P 500, up 1.4%, with the Russell 2000 up 1.0% and the NASDAQ up 0.8%.

To what do we credit such strong close to a relatively flat month where strong openings were typically followed by very weak closes? Last week, despite many good starts, only Large-cap Value ended the week positive, gaining 0.16%; Small-cap Growth dropped a nasty 4.28%. President Putin’s call to President Obama gave hope for a diplomatic settlement to the Ukrainian issue. Or, one could argue that Fed Chairman Yellen’s remarks that the Fed remains short of its employment and inflation targets created a feeling that the Fed might taper a bit more slowly, charging today’s market. Of course, EOQ window dressing might have been the real trump card. Regardless, we are once again nearing various index highs with the strength from today’s rally.

Reaching new highs might once again raise the issue of valuation in Q2. We completed our quarterly analysis of Sabrient GARP ratios (growth at a reasonable price) to measure valuation. You might recall that the Sabrient top 300 GARP stocks reached a historic low in February 2009, as did Sabrient’s 1000 best GARP stocks. The indices are composed of a nearly 2500 stock universe that includes all publicly held domestic companies that have at least three IBES analysts following them.

The forward P/E of the Sabrient 300 averaged the historically low figure of 6.46 on March 6 of 2009. By May of 2011, it had reached a high of 9.37 before the summer pull back in 2011. By early 2012, it had risen again to nearly 10 with an average of 9.44. Once again, it fell back reaching 7.75 in the summer of 2012. From that low, the resulting strong market drove it to 10.69 February 2013. It had been relatively stagnant since that time until moving above 10 in late 2013 and now reaching its post 2009 high of 11.84 on Friday. Perhaps 12 by todays close.

Even the Top 1000 Sabrient GARP stocks have moved across 15, which we haven’t seen since the dot com boom early in the 2000’s when it was well above 20 (the Top 1000). However the Top 300 never were much over 17, so current valuations are about 80% or so above 2009’s lows while remaining about 40% below dot com highs. Interest rates are well below dot com highs, so at or near current rates, favorably priced growth stocks are more than 50% below interest rate adjusted highs of the frothy market of the early portion of the 2000’s.

While interest rates will likely rise further, it seems quite unlikely that they will reach formerly high rates anytime soon. Our conclusion is that bargain growth stocks remain at historically average levels and should be sought by the prudent investor especially with the risk of high interest rates threatening the fixed income market. Our Sabrient SectorCast report favors stocks from the technology, financial or healthcare sectors.

Market Stats

One note of caution! Nearly 50% of the Sabrient top 1000 GARP stocks are projected to earn less in their next quarter than the same quarter a year ago. The forward P/E takes this into account by its very calculation, but this is by far the highest number of the top 300 or Top 1000 to be facing lower quarter over quarter earnings. Will the economy grow enough to offset these projections as few companies can really afford to cut costs much more? We will closely watch the forward PE’s as well as the ratio of stocks projected to earn less quarter over quarter.

3 Stock Ideas for this Market

The following stocks were selected from the top of our stock universe with great earnings growth projections, reasonable valuations and recent upward revisions to earnings estimates.

JAZZ Pharmaceuticals (JAZZ) –Healthcare

Trading for 40x current earnings and 14x forward earnings estimates
Recent sell-off has provided cheaper entry point
Analysts have revised earnings estimates up in the last 7 days
39% projected EPS growth current quarter, 38% next quarter, 30% in 2014, 24% next year, 20% 5-year

Alaska Air Group Inc. (ALK)—Industrials

Trading for 13x current earnings and 12x forward earnings estimates
Analysts have revised EPS estimates up in the last 7 days
58% projected EPS growth current quarter, 34% next quarter, 26% in 2014, 14% 5-year