Thursday's Decline-Correction Or Something Worse?

The weight of evidence currently suggests that we are experiencing nothing more than a normal correction. 

The market was very over bought at the end of April. I have discussed that before here and here. Equities become over bought when they reach a point where there are no buyers at current prices. At best stocks will then trade in place while they work off these conditions. Often what happens is that they decline to price levels that again attracts the interest of investors. That is what seems to be occurring now. Stocks staged an impressive 13% rally from early February to the end of April. At some point this rally was destined to roll over given the nature of that advance. All that was needed was an event to set a decline in motion. I'll argue that it was a combination of the Government's case against Goldman Sachs, the oil leak in the Gulf and the economic troubles in Greece that lit the fuse. Even if none of these events had occurred I think there would have been something else giving investors a reason to take profits.

The economy is on the mend. Lost in the background is the fact that the economy is improving. This is in sharp contrast to when the market crashed in October, 2008. Back then there was ample evidence that economic growth was already decelerating. In contrast corporate earnings are beating estimates for the fifth quarter in a row** According to a report issued by Deutsche Bank this week, corporate earnings per share have come in a strong 20% above consensus for the firms that have already reported this quarter. Estimates going forward are also being revised higher.

The Labor Department reported yesterday that non farm payrolls rose 290,000 in April with gains reported across almost every business sector. This was the the fastest pace of job gains in four years. and also the largest gain since March 2006. Adding this to March job revisions, this suggest that nearly a half million jobs have been created in the past two months. You simply do not get this kind of job growth when corporate managers are concerned about economic contraction.

Corporate earnings continue to be revised higher. S&P 500 earnings estimates have recently been moving north of $80 per share for 2010. Earnings for 2011 are currently in the $85-90 dollar range per share. Critics of these numbers forget that the S&P 500 earned $86 per share in 2007.  I think that upside to this year's earnings number may back off a bit soon due to the troubles in Europe and oil spill in the Gulf. But I still think $80 per share is a pretty good baseline on which to gage market valuation by year end.

Valuations are still attractive. In an expanding economy with ultra low interest rates, traditional valuation methods suggest a price to earnings multiple of 14-17 times that S&P $80 earnings number. Traditional valuation methods would therefore suggest a price potential of 1120-1360. That gives us a market that is either fairly valued at current levels to one that has the potential to gain 12-21% by years end.  Also the earnings yield-the earnings divided by stock price-for the S& P 500 currently is about 7%.  This compares favorably with corporate bond rates and money market accounts yielding almost nothing. 

There is of course no guarantee that such levels will be reached or that markets might not head lower even in the short term. Indeed our current problems could prove this analysis moot. Greece for example could lead to a larger European problem, especially if it does spread to Spain, Portugal or Ireland. Also an unforeseen event such as a successful terrorist incident on par with 9-11-2001 or a massive natural disaster would negate much of my current analysis. I am constantly checking what I believe about the market to the facts on the ground and I stand ready to change my thinking should events warrant. But given what we know at this time there is the potential for stock prices to reach these levels on a six-nine month basis.

Tomorrow I'll discuss how the playbook says we should adjust the game plan to current events.

*Long ETFs related to the S&P 500 in client accounts.

(Blue highlights represents links to older posts)
**Source Deutsche Bank, US Equity Strategy, Chadha, Binky, 04.27.2010