That little selling jag is in the rear view, or at least we can hope. After the S&P 500 hit its all-time closing high of 1,593.37 on 4/11/13, the index slid 50 points lower within a (barely established) pattern of lower highs and lower lows. At a close of 1,541.61 on 4/18/13, the S&P 500 found support at its 50-day simple moving average (SMA) trendline. A raft of positive earnings "surprises" (stage-managed as always) cheered the stock market back up above the lower high of 1,575 from 4/16/13.
Before you think, "we're out of the woods," remember: in the market you are never out of the woods; you just move from clearing to clearing. The risks of a second-quarter selloff are as intense as ever, based on recent history (the 5.6% average 2Q decline for 2010-2012); distorted seasonal data "adjustors" that may be sending false economic signals, based on warmer winters and cooler springs; and plain old consolidation in fast-growing consumer markets (housing, automotive) that may be due for a pause.
While we see little likelihood that the market escapes 2Q13 unscathed, we still anticipate additional upside in stocks for 2013. For the past three years, second-quarter market declines have primed the pump for a second-half advance, for all the usual reasons. Selloffs tend to shake out low-quality names; pull in sideline-sitters reluctant to buy into the market at the top; and allow valuation re-sets, as stocks return to prior-month or prior-quarter price points but at a higher level of earnings.
Mainly, the market continues to look attractive at current levels - particularly if, as seems likely, 1Q13 forecasts for earnings prove too conservative. Prior to the quarter, the consensus of top-down strategists was that 1Q13 EPS from continuing operations would decline about 2%. As of midday on 4/23/13, about one-quarter of the S&P 500 (131 companies) had reported calendar 1Q13 results. On a market cap-weighted basis, earnings for those companies grew an average 10.6% from 1Q12 (on an un-weighted basis, the change was +7.7%). Ninety-one, or 69.5%, of those companies reported positive surprises, versus just 18.3% reporting negative surprises.
All investors know the game is rigged. CFOs have zero motivation to offer a true assessment of EPS prospects; merely hitting your number is an invitation to a stock selloff. But within the shared hallucination of earnings guidance, some truths stand out. Disguised or not, earnings continue to rise, and stocks are being pulled along.
In 2008, S&P 500 earnings from continuing operations were $49.49. For 2013, Argus forecasts S&P 500 earnings from continuing operations of $110.80 - up 123.9% from the 2008 low. From the 3/9/09 low of 676 to the 4/23/13 reading of 1,577, the S&P 500 is up a slightly better 133%.
By this analysis, all the policy intrigue and geopolitical wrangling in the intervening years means nothing. The European sovereign debt crisis? A false alarm. The sequester? A head fake. The essential lesson is that earnings go up, stocks follow, and the rest is just headline fodder.
We forecast 2013 continuing operations EPS of $110.80 on the S&P 500 and 2014 EPS of $122.50. Both estimates imply continuing operations EPS growth in high single digits, and as such support additional market upside.
We also regard current equity valuations as supportive of further upside. Based on our estimate of "centered" five-year earnings power (three years historical, two years forecast), we calculate $101.80 in "normalized" earnings for the S&P 500. On normalized EPS, and using the 4/23/13 S&P 500 price level of 1,577, this market is trading at 15.4-times. We have calculated a "justified" multiple of more than 18-times, based on historical valuations, dividends, the current level of bond yields, and other inputs. Our justified multiple suggests that stocks are 15%-18% undervalued.
We believe that bull markets follow somewhat predictable patterns. Off the market bottom, earnings recovery is driven by margin expansion as lean-running, down-cycle survivors position for profit growth. The middle stages of a bull market are characterized by earnings growth, initially from margin expansion and then from revenue growth. In this middle stage, earnings and revenues can continue growing after margins top out. In the final stage of a bull market, margins are capped, revenue growth is sluggish to nonexistent, and earnings are no longer growing.
The first stage of any bull market is characterized by deep investor skepticism; the best time to get in is when hardly anyone wants in. Institutional investors enthusiastically drive mid-stage bull markets. Stocks tend to keep rising in late-stage bull markets, usually for all the wrong reasons. Individual investors, notoriously late to the party, finally succumb to the rising trend and their own greed. Institutional investors also need to match or beat the market, and so they abandon any lingering bearish feelings - again, at precisely the point at which their inner bears should be asserting themselves.
At some point, earnings will stop growing. When earnings growth slows or stops, does the bull market stop? Not all at once. As the market keeps going up amid slow to stagnant earnings, P/Es inflate. We're not there yet. But given prospects for yet another second-half market surge, and given the age of this market, valuations matter much more now than they did a few years ago.
We took a look at P/Es going into and coming out of seven bull markets between 1960 and the beginning of the 2008 recession. These seven bull markets had an average duration of 44 months by our math (some investors treat the 1990 to 2000 market as one bull market, which would make for six bull markets with an average duration of 54 months). Our calculations are based on S&P 500 price levels; S&P 500 earnings from continuing operations; and quarterly P/E data from Bloomberg.
In almost every case, P/Es were low going in; initially flared higher but eventually moved lower than opening levels in the middle stages of the bull market; and then spiked as the bull market reached its finale. For these seven bull markets, we calculate a beginning P/E that averages 15.4-times current-year earnings. The average at the end of these seven bull markets was 20.9-times. The ending P/E for the seven bulls was on average 550 basis points higher than the beginning P/E. In only one instance was the beginning P/E higher than the ending P/E: the bull from March 2003, when the P/E was 17.8, to October 2007, when it was 17.3.
We mark the current and ongoing bull market as having begun in March 2009 (and having just "bearly" avoided a bear-market ending in July-August 2011, when the market fell 17%). From a duration perspective, the current bull is looking old, at 49 months compared with our average of 44 months for the preceding seven bull markets. But, based on how P/Es have behaved during those seven bull markets, this bull still has some room to run.
In March 2009, the S&P 500 traded at 13.1-times (depressed) earnings. For all of 2009, P/Es averaged 16.4-times, as investors bid stocks up and earnings raced to catch up. For the prime bull years of 2010 through 2012, P/Es ranged from 13.8-times (2010) to 13.1-times (2011).
Earnings growth has slowed from the rah-rah years of 2009 and 2010. But earnings continue to grow, and that is keeping valuations reasonable. Based on our forward earnings estimates, the market in mid-April 2013 is trading at 14.2-times our current-year estimate of S&P 500 earnings from continuing operations, and at 12.9-times 2014 forecast earnings. That produces an average two-year forward P/E of 13.6-times.
Remember, ending P/Es in post-WWII bulls have been 550 basis points higher than initial P/Es. Applying that math to the 13.1 P/E from March 2009, the "predicted" ending P/E for this market would be 18.6-times forward earnings. We doubt we will see a P/E that high, given how badly investors were scarred by the two selloffs in this millennium: the internet implosion of 2001-2002, and the banking collapse of 2008-2009. Even a 300- to 350-basis-point premium to the beginning-bull P/E is going to seem stretched.
But that's not to say the market has no further room to run. Whether we use our "normalized" P/E of 15.4, or an average two-year forward P/E of 13.6, valuations do not appear stretched. And earnings, far from slowing, appear to be growing. In assessing the bull's health, stagnation in EPS would be the first red flag; P/E expansion would be the second. So far, there are no red flags in this long-running bull rally.