Why the S&P is too cyclical to be cheap

It's been a mixed few weeks for the major US indices. Even after the recent turmoil, the Dow Jones Industrial Average is still up around 2% since the start of the year, while the S&P 500 is slightly down. The Nasdaq Composite has slumped to its lowest level in 13 months after a string of poor earnings reports from technology companies.

The relative performances of the Dow and the Nasdaq are understandable. After all, in these troubled times, investors are choosing to put their money into sturdy old-economy companies and avoiding risky tech stocks. True, some of those Dow stalwarts look less than sound themselves take a bow Ford and GM but who ever said that markets were rational? However, the S&P's weakness has seen many commentators arguing that it now looks outstandingly cheap. The index trades on a forward p/e ratio of around 14, which is far too low at a time when non-tech earnings growth remains extremely strong, say the bulls.

Dig deeper, though, and you find reasons why it may not be such a bargain. "We think that such reasoning is incorrect, because it ignores the cyclicality of earnings and inflation," says Richard Bernstein of Merrill Lynch. He calculates that because lower-quality, more cyclical stocks make up a larger proportion of the index than they have historically, the cyclicality of the S&P 500's earnings is at an all-time high. This means that valuing the S&P on the basis that the recent strong earnings performances will continue is suspect, because of the risk of a cyclical earnings downturn. A low forward p/e could be justified by this earnings uncertainty.

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In addition, Bernstein believes that higher inflation will persist longer than many expect and that "investors do not seem to realise that there is an inverse trade-off between p/e ratios and inflation". His inflation versus p/e model suggests that, far from being cheap, the S&P is still 5%-10% overvalued.

Bernstein also looks at several other cyclical markets around the world and finds that while their current p/e ratios are low, one-year forward p/e ratios are rising. In other words, analysts in these markets think that earnings already have peaked and expect a downturn. Maybe the S&P will be different or maybe US analysts are just being over-optimistic.