Quarterly Letter to Clients Part III

Today we will finish up the discussion on market valuations that we began yesterday.  What stands out for us from yesterday's chart is that stocks are currently trading at levels similar to the Gulf War low back in 2003 and not that much above the generational lows of March, 2009. Historical studies of PE ratios suggest that the S&P 500 index has on average traded between 14 and 16 times their forward looking estimates on a PE basis. We also compute that the average earnings yield on the S&P 500 since 2000 to have been 5.70%. Using these metrics and a midpoint 2012 earnings estimate of $104 on the S&P 500 then on a historical PE value the market could trade between 1,442 and 1,648. To bring the earnings yield back down to its historical levels the S&P 500 would need to trade this year to around 1,750.

Keep in mind that these are historical observations, likely skewed by the fact that stocks were very overvalued throughout the first half of the last decade. Probability suggests that a year end 2012 price value north of 1600 is highly unlikely. However, this sort of exercise does show you that based on what we know today, the valuation potential for equities is still very attractive on a multiyear basis.

This kind of data reflects many of the fears that investors believe could affect stocks in the coming year. First and foremost are the unfolding events in Europe. I think it will be very unlikely to completely undo the Euro. The European nations resemble a large dysfunctional family where the members don’t like each other very much but regardless are stuck together whether they like it or not. They might kick Greece out, but my guess and bet is that the Euro survives intact. Irrespective of what I think it will be the actual events over there that impact markets. The effort by various entities over there to inject capital and backstop the individual countries and banks has so far this year been a positive impact on markets.

There are other things concerning investors. The volatility of the past few years has been very frightening. US economic growth has been anemic. High unemployment and the housing crisis are constantly in the news. The poisonous atmosphere and gridlock in Washington shows no signs of abating. Washington’s policies are seen by many as being largely anti-business and if you are not a fan of the President then you cannot be happy about the current state of the Republican campaign. However, much of this already discounted and investors are ignoring some very positive developments.

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

{Tomorrow we begin a discussion on what if things are getting better.}