Netflix (NASDAQ:NFLX) and Bank of America (NYSE:BAC) and The Valuation Risk Spectrum

July 19, 2016, 09:32 am ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

Netflix (NASDAQ:NFLX) and Bank of America (NYSE:BAC) define opposite ends of the Market’s valuation-risk spectrum.

Let’s start with some facts.  The PE multiple on the S&P 500 as reported by S&P Dow Jones Indices is currently 23.83x but it is expected to improve over the next 18 months if analysts are right about their estimates for calendar 2017.  At the end of next year, the PE multiple is expected to drop to 17.36x.

Currently, the earnings growth rate for the S&P 500 is negative, earnings growth for the dow Jones industrial average has been negative for a while, and revenue is declining.

Margin debt ratios on the New York Stock Exchange as reported by the NYSE show us that the cash to margin debt ratio on the NYSE is near an all-time low, suggesting that institutional investors have far fewer dollars to invest when compared to their margin debt than ever before in history.

Although very few expect this, the FOMC already has ample reason to raise rates when they meet next week, and I expect them to do exactly that.  The recent increases in the stock market give them additional cushion, and according to the minutes of the FOMC from last time their main concern was the Brexit vote, and that currently seems like a non-event after the initial gyrations.

With those facts in tow, we’re still seeing a market that has pressed higher, but that does not mean it is without risk.  In fact, quite the contrary, risks are extremely high, but the recent sentiment on the street has been to treat bad news as good, good news as great, and to largely ignore macro-economic conditions.  They are even ignoring bad earnings results when earnings beat already awful expectations.  That is exactly what happened with Bank of America.

Before anything else, it’s important to notice that Bank of America increased by about 14% before earnings were released and then increased even more on the heels of significant earnings and revenue decline.  Yes, they were not as bad as expectations, but the stock increased by about 20% in a very short period of time which causes me to question the stock’s reaction to bad growth.  Everyone seemed excited after the earnings release, with the exception of a few.

The argument seemed to be that BAC only had the PE multiple of 11x earnings so when compared to the PE multiple of 23x earnings for the S&P 500 the stock looks cheap, but it still has negative growth rates, which begs the question, what exactly is cheap?

That leads us to the second example, Netflix.  With a PE multiple of 90x forward looking earnings expectations for accelerated growth existed, but after the earnings release on Monday those growth expectations are being questioned and suddenly investors are concerned about valuation.

Therein lays the risk across the board in my opinion.  We’re in a market that does not care about valuation currently, they seem to think negative growth is cheap, some investors are willing to pay 23x earnings for the S&P 500 too, even though that is an extremely high historical multiple, and looking out 18 months the multiple is still historically high at over 17x earnings, but investors who are buying today seem to be willing to wait.

They don’t seem to care, but if they ever do start to respect the valuation levels of the S&P 500 again, the negative earnings growth rates, the high margin debt ratios, and the lingering risk of higher interest rates, multiple contractions may come, bring the market down to levels that more match reduced growth rates and cause those people who are currently expecting to wait 18 months before valuation comes down to wait much longer than that before getting back to break even.

Investors in Netflix realize that valuation matters again already, where they didn’t seem to care last week, and one day we all may wake up and realize that the investment community actually cares about the excessive valuation in the market too; that day will come in my opinion.

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