Are Stocks Cheap?{ Part II}
This is the 2nd article in a series we are going to do between now and the beginning of next year discussing what might be in store for us in 2011. In our first article I reviewed our previous earnings projections and discussed our basic methodology on how we derive our forecasts for the year ahead. We've also started discussing here a few weeks ago earnings possibilities for the markets in 2011. In that post we brought up the possibility of the S&P 500 trading between 1,350 and 1,400 by the end of 2011. I think there is a greater likelihood of that occurring now than I did a few weeks ago and today I'll explain why I think that is possible.....
......But first the lay of the land:
Both the US and world economies have been mired in a very tepid jobless economic recovery that has for the most part been dependant on massive aid from governmental authorities. Europe has the issues of of sovereign countries such as Ireland, Greece and Portugal. Here we have the issues of among other things stagnant economic growth affecting local and state governments. Both economic zones have been savaged by the ongoing housing crisis. Unemployment is high in both regions. Furthermore it is unclear how much of the ongoing problem with unemployment is structural {technology led enhancements to productivity for example} versus cyclical.
The economic situation hasn't been helped here by the perception by business leaders that the current Obama Administration and the current Congress have pursued policies that are at best confusing towards business and at worst are biased against that community. However it is important to point out that these issues have now been well discounted in the markets.
In the past few weeks we have seen a few positive developments. As noted here on Friday, consumers continue to delever their personal balance sheets. Many indicators of future growth {capacity utilization rate, ISM and Federal regional growth indices for example} have also shown improvement recently. The jobless picture continues to improve somewhat {albeit still at very high levels}. Also the tax compromise announced last week between Congressional Republicans and the President remove fiscal uncertainty until after the 2012 elections. Finally the Government last week announced that they would divest themselves of the last of their Citigroup stock.. This is further evidence that financial institutions have significantly repaired their balance sheets which is a precursor to a better lending environment and ultimately economic growth.
Economic surprise to the upside?
If anything I think it is possible that the economy will do better in 2011 and again in 2012 than most look for today. This view is starting to be recognized in the financial community. GDP growth is now forecast by many to be somewhere between 2.5%-3% for 2011 and at least one firm {Goldman Sachs} thinks GDP growth could near an annualized 4% level by 2012. As such brokerage firms are ratcheting up their year end estimates for the S&P 500.
Right now consensus estimates for year end 2010 are between $84-86. Assuming a year end PE {price to earnings ratio} of somewhere between 13-15 times these earnings, this implies fair value for 2010 is somewhere between roughly 1100-1290. If we use a median of $85 and a year end multiple of around 15 then fair value for the S&P 500 is somewhere between 1,250 & 1,275. The index on Wednesday {the time of this writing} at 1223.75. That implies potential upside of 2-4% by year's end.
Our friends at Chart of the Day have picked up on this as well. According to them, "the recent rise in earnings as well as the recent stock market correction has impacted the current valuation of the stock market as measured by the price to earnings ratio (PE ratio). Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1900 into the mid-1990s, the PE ratio tended to peak in the low to mid-20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s), surged even higher during the dot-com bust (early 2000s), and spiked to extraordinary levels during the financial crisis (late 2000s). As a result of the recent spike in corporate earnings, however, the PE ratio currently resides at a level not often seen over the past two decades." {Link: Earnings & PE Ratios}
Consensus estimates for earnings in 2011 have accordingly been moving higher as evidence of a strengthening world economy continues to emerge. Current S&P estimates for 2011 seem to reside between $93 and $96 a share. Analysts are consistently told they are too optimistic when making such forecasts twelve months in advance. Given what we've discussed above it is possible that these numbers could prove conservative for the next year.
If these estimates prove to be accurate then fair value for next year on the S&P 500 has the potential to be somewhere in the range of 1,250 {roughly 13.5 times a $93 S&P earnings estimate} and 1,450 {a bit more than 15 times that $96 S&P number}. I will use as a starting point for next year at this time of 1,375 by year end. That is halfway between my own internal 2011 fair value estimate of 1,350 and 1,400. This is a PE of roughly 14.5 times a midpoint estimate of 94.50. I think these numbers have the possibility of moving higher as the new year unfolds.
Note that a market that trades somewhere next year between 1,350 and 1,450 would only get us back to where stocks first traded in 1999 and were last seen in January of 2008!
But wait there's more!
One final thought. If we assume that the economy continues to grow at these projected rates then you are looking at 2012 estimates of potentially $100 and $104. Should these numbers come to pass then you are looking at fair value estimates out there of $1,350-1,550 by year's end 2012. That's a long way out and there are many reasons why that might not occur. However, that is what the math tells us is possible if the economy stays on its current glide path.
There are many reasons why this may not come to fruition of course. Some of these {war in Korea for instance} are known. It is more likely however that the event that could potentially keep this scenario from occurring is not today known. Yet absent some unexpected development these estimates are possible based on the economic numbers.
The economic situation hasn't been helped here by the perception by business leaders that the current Obama Administration and the current Congress have pursued policies that are at best confusing towards business and at worst are biased against that community. However it is important to point out that these issues have now been well discounted in the markets.
In the past few weeks we have seen a few positive developments. As noted here on Friday, consumers continue to delever their personal balance sheets. Many indicators of future growth {capacity utilization rate, ISM and Federal regional growth indices for example} have also shown improvement recently. The jobless picture continues to improve somewhat {albeit still at very high levels}. Also the tax compromise announced last week between Congressional Republicans and the President remove fiscal uncertainty until after the 2012 elections. Finally the Government last week announced that they would divest themselves of the last of their Citigroup stock.. This is further evidence that financial institutions have significantly repaired their balance sheets which is a precursor to a better lending environment and ultimately economic growth.
Economic surprise to the upside?
If anything I think it is possible that the economy will do better in 2011 and again in 2012 than most look for today. This view is starting to be recognized in the financial community. GDP growth is now forecast by many to be somewhere between 2.5%-3% for 2011 and at least one firm {Goldman Sachs} thinks GDP growth could near an annualized 4% level by 2012. As such brokerage firms are ratcheting up their year end estimates for the S&P 500.
Right now consensus estimates for year end 2010 are between $84-86. Assuming a year end PE {price to earnings ratio} of somewhere between 13-15 times these earnings, this implies fair value for 2010 is somewhere between roughly 1100-1290. If we use a median of $85 and a year end multiple of around 15 then fair value for the S&P 500 is somewhere between 1,250 & 1,275. The index on Wednesday {the time of this writing} at 1223.75. That implies potential upside of 2-4% by year's end.
Our friends at Chart of the Day have picked up on this as well. According to them, "the recent rise in earnings as well as the recent stock market correction has impacted the current valuation of the stock market as measured by the price to earnings ratio (PE ratio). Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1900 into the mid-1990s, the PE ratio tended to peak in the low to mid-20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s), surged even higher during the dot-com bust (early 2000s), and spiked to extraordinary levels during the financial crisis (late 2000s). As a result of the recent spike in corporate earnings, however, the PE ratio currently resides at a level not often seen over the past two decades." {Link: Earnings & PE Ratios}
Consensus estimates for earnings in 2011 have accordingly been moving higher as evidence of a strengthening world economy continues to emerge. Current S&P estimates for 2011 seem to reside between $93 and $96 a share. Analysts are consistently told they are too optimistic when making such forecasts twelve months in advance. Given what we've discussed above it is possible that these numbers could prove conservative for the next year.
If these estimates prove to be accurate then fair value for next year on the S&P 500 has the potential to be somewhere in the range of 1,250 {roughly 13.5 times a $93 S&P earnings estimate} and 1,450 {a bit more than 15 times that $96 S&P number}. I will use as a starting point for next year at this time of 1,375 by year end. That is halfway between my own internal 2011 fair value estimate of 1,350 and 1,400. This is a PE of roughly 14.5 times a midpoint estimate of 94.50. I think these numbers have the possibility of moving higher as the new year unfolds.
Note that a market that trades somewhere next year between 1,350 and 1,450 would only get us back to where stocks first traded in 1999 and were last seen in January of 2008!
But wait there's more!
One final thought. If we assume that the economy continues to grow at these projected rates then you are looking at 2012 estimates of potentially $100 and $104. Should these numbers come to pass then you are looking at fair value estimates out there of $1,350-1,550 by year's end 2012. That's a long way out and there are many reasons why that might not occur. However, that is what the math tells us is possible if the economy stays on its current glide path.
There are many reasons why this may not come to fruition of course. Some of these {war in Korea for instance} are known. It is more likely however that the event that could potentially keep this scenario from occurring is not today known. Yet absent some unexpected development these estimates are possible based on the economic numbers.
Next in this series will discuss interest rates and the presidential cycle. After that in future articles we'll take a long term look at the technical picture, we'll discuss what could go wrong with this analysis and finally take a look at what both the playbook and game plan tells us to do.
*Long ETFs related to the S&P 500 in client and personal accounts.The above article is not meant to be construed as a recommendation, guarantee or prediction of any sort. It is one of many possibilities that could occur in the next year. I write solely for the clients and friends of Lumen Capital Management, LLC. As such I write with a basic understanding of the risk/reward criteria of my audience. An outside or casual reader of this blog needs to consult with their own investment advisor or do their own homework before responding to anything written on this blog. Better yet hire us and let us show you how we do our work for clients.
posted by CR English at 6:07 AM
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