Evaluating Current Market Levels with S&P 500 Having Reached My Fair Value Target

I have written here previously that my personal fair value target for the S&P 500 index was around 1,050. I got there by using an average P/E multiple of 14-15 and projecting a “normalized” earnings run rate for the index of around $70 annually. The index has now risen 60% from its March low and hit a level of 1,074 intraday on Thursday, about 2% above my target. Naturally, the next question is “what now?”

First we need to reevaluate my initial assumptions to determine if they need to be revised. Current earnings estimates on the S&P 500 for 2009 are about $54, which is a 9% increase from 2008. Estimates going forward are significantly higher than that, at around $73 for 2010. Does my $70 still apply?

In my mind it does. The idea behind trying to determine “normalized” earnings is to eliminate the long tails of the distribution. Valuing stocks based on earnings during a recession ($50-$55) is not very helpful given that the economy grows during the vast majority of all time periods. Conversely, using the previous peak earnings level ($87) factors in a period of easy credit and dramatic leverage which surely boosted profits to unsustainable levels.

So, I would define “normalized” earnings as the level of corporate profits that we could expect in neither a recessionary environment (negative GDP growth), or a highly leveraged economy (say, 4-5% GDP growth). Put another way, what would earnings be if the economy was growing, but not very fast (say, by 2% per year). Something between $50 and $87 most likely, and the number I have been using is $70 for the S&P 500.

Interestingly, the consensus for 2010 is for moderate economic growth, positive but not at the pace we saw earlier this decade. Given that the current earnings estimate for next year is $73, I believe my $70 figure still makes sense, given what we know right now anyway.

Where does that put us in terms of the market? Well, in my mind we are trading pretty much at fair value, but it is helpful to look at both the more bearish case and the more bullish case to get an idea of what the risk-reward scenario looks like. Comparing your potential upside with the corresponding downside should make it easier for investors to gauge how they should be allocating their investment capital.

First, the bears will argue that earnings are being helped merely by cost cutting and that revenue growth will be non-existent because the economy will remain in a rut for a long time. They will contend that earnings in the $70 range for 2010 is overly optimistic and will cite the $54 figure for this year as a more reasonable expectation in the near term. Assign a 14-15 P/E (the median multiple throughout history) on those earnings and you get the S&P 500 index trading between 750 and 800, or 25-30% below current levels.

Next, we have the bulls on the other end of the spectrum. They believe that slow to moderate growth in 2010 is likely and S&P 500 earnings in the $70 to $75 range are reasonable expectations. They go further and argue that given how low interest rates and inflation are presently, P/E multiples should be slightly above average (the argument there being that low rates and low inflation make bonds less attractive and stocks more attractive, so equities will fetch a premium to historical average prices). They will assign a 16-17 P/E to $73 in earnings and argue that the S&P 500 should trade up to around 1,200 next year, giving the market another 10 to 15% of upside.

From this exercise we can determine the risk-reward using all of these arguments. Bulls say 10-15% upside, bears say 25-30% downside, and I come in somewhere in between at a flat market. Therefore, I am cautious here with the S&P 500 trading at 1,066 as I write this. To me, aggressively committing new money to equities at these levels comes with a fair amount of risk given that the best case scenario appears to only be another 10 or 15 percent. As a result, I am holding above average cash postions and being fairly defensive with fresh capital. There just aren’t that many bargains left right now, so I am hoping the next correction changes that.

Comments

[Mad Hedge F...:]

eery Ouch! So much for my “Sell the Tenth Consecutive Up Day” model. I shorted the S&P 500 September 1050 calls, which expire in two days. The trade was looking good all the way until this morning, when I got stopped out with a 0.5% hickey. It’s no excuse that this works 99% of the time. This is well and truly a liquidity driven market, the kind I used to feast on in Tokyo during 1987-89, when we took Japan’s PE multiple up to 100. The S&P earnings multiple has now made a round trip from 18 times in 2007, to 10 times in March, and back up to 18 times today. Worse, the previous 18 peak was in an era of far rosier economic projections than we are currently grappling with. Don’t fight the tape. Stand out of the way, and let the insanity play itself out before rebalancing your portfolio. At least I have my gold, silver, copper, crude, junk bond, emerging markets, FCX, BYD, water ETF, and short dollar profits to drown my sorrows in.

Sep 18 01:01 PM

[Mad Hedge F...:]

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Sep 18 01:09 PM

[Larry House:]

I think you build a reasonable case, Chad. You have as much of a chance as anyone of being right. The game-changers would be another crisis in our financial system, larger job losses, currency crisis, greater consumer contraction, unrealistic earnings estimates, our government doing something stupid--there are a lot of things that can go wrong. Let's hope they don't but invest as though they might.

Sep 18 01:58 PM

[75 Year Old...:]

Bulls make money , Bears Make money , PIGS Get slaughtered
Time to take Your Profits , and relax while the PIGS start falling all over themselves running for the exits very soon . Just Before Dow 14,000 Dropped like a Rock , the Gurus were calling for Dow 16 17 and even 18,000 , Look s like were in that place again , this rally is built on little more then HOPE and Happy Talk that things will get bettter , Would You buy a stock on that SOLD HOPE and Happy Talk ?

Sep 18 02:08 PM

[Original Sc...:]

I really appreciate your analysis. I would give it great credibility if we existed in a world of free and honest markets.

I still hold the belief that the S&P earnings are way over stated and the stock prices are help up artificially by the PWFM (PPT).

The economy is still shrinking, employment is shrinking, birth death models are a lie, credit is still too tight, and the bad news of next 1/4 financials for the banks must provide mark to market. Since the banks have been hiding huge amounts of toxic assets on their books via mark-to-model, they must either find the next loophole or the next accounting scam as there is no one to sell these to but each other. JP Morgan alone has more derivative exposure than the GDP of the entire world. This is not a sign of a health investment environment.

Sep 18 02:10 PM

[Tom Armistead:]

Very good common sense analysis. I have been working with a target of S&P 1,200 by the end of next year, which leads me to manage my portfolio along similar lines - extra cash, careful about the commitment of additional funds. I have also been rotating out of small tech, lower cost and extreme value type cases into more defensive stocks like JNJ, PG, etc.

Sep 18 03:11 PM

[TheFounder:]

I observe 3 groups of traders:
1) people who believe the recession is over and we are in a real recovery related bull market (25% or less)
2) those who believe this is a bear market rally but one with strong momentum (either because of the stimulus or because of the strength of the pre March declines) which can take us to 1150-1200 (50%)
3) those who sold too soon and are awaiting another decline to justify their action (25%).

Groups # 1 and 2 are strong enough to support this rally. But it will be primarily group # 2 that take the market down when they will feel they had enough. Probably somewhere between 1100 and 1200.

Sep 18 04:36 PM

[untrusting ...:]

But you forgot the most important group of traders ... GS, JPM, and the HFTer's, algo traders, flash traders, etc. who account for a maximum of 2% of the market participants but who have accounted for as much as 50-70% of the entire market volume for months now. They are far more important than any of the other 98% that you mention, which are not all of the market in any event.

You also forgot to mention the bond markets which at this point according to reports are experiencing over 10x the inflows that equities are.

The overall conclusion is apparently very few have any confidence in the rally whatsoever. It certainly appears that the LT smart money such as Hussman, Kass, etc are fully hedged meaning they expect significant corrections, otherwise they would not be willing to pay for downside protection. Guess we will all find out over the coming months.


On Sep 18 04:36 PM TheFounder wrote:

> I observe 3 groups of traders:
> 1) people who believe the recession is over and we are in a real
> recovery related bull market (25% or less)
> 2) those who believe this is a bear market rally but one with strong
> momentum (either because of the stimulus or because of the strength
> of the pre March declines) which can take us to 1150-1200 (50%)<br/>3)
> those who sold too soon and are awaiting another decline to justify
> their action (25%).
>
> Groups # 1 and 2 are strong enough to support this rally. But it
> will be primarily group # 2 that take the market down when they will
> feel they had enough. Probably somewhere between 1100 and 1200.

Sep 18 05:53 PM

[JeffDB:]

On Sep 18 02:10 PM Original Scruffy wrote:

> I still hold the belief that the S&P earnings are way over stated and the stock prices are help up artificially by the PWFM >

I'm not familiar with that acronym. "Powers With Funny Money"? ;)

Sep 18 08:52 PM

[Guillaume:]

I like & concur with your analysis.
I guess I am part of group 2 actually.
still long as we speak, but will trigger between 1100 & 1200.

Where I diverge is on the probabilities. My sense is that group 3 is in my view the vast majority, combining retail & the professionals who have gone out no later than 1 year / 18 months ago. It was still time to cure their wounds in spring 2009 (if they still had a job) which may explain why they did not have the risk appetite to put any any money at risk.
I have learned from my past 20 years experience trading that my worst trading losses came from being short in a short squeeze or a bear market rally - not part of it this time, but I know what it feels like.

The sensation that group 3 is still fairly large & kicking gives a lot of support and confidence to group 1 & 2...



On Sep 18 04:36 PM TheFounder wrote:

> I observe 3 groups of traders:
> 1) people who believe the recession is over and we are in a real
> recovery related bull market (25% or less)
> 2) those who believe this is a bear market rally but one with strong
> momentum (either because of the stimulus or because of the strength
> of the pre March declines) which can take us to 1150-1200 (50%)<br/>3)
> those who sold too soon and are awaiting another decline to justify
> their action (25%).
>
> Groups # 1 and 2 are strong enough to support this rally. But it
> will be primarily group # 2 that take the market down when they will
> feel they had enough. Probably somewhere between 1100 and 1200.

Sep 18 09:30 PM

[Ricard:]

"They go further and argue that given how low interest rates and inflation are presently, P/E multiples should be slightly above average (the argument there being that low rates and low inflation make bonds less attractive and stocks more attractive, so equities will fetch a premium to historical average prices). They will assign a 16-17 P/E to $73 in earnings and argue that the S&P 500 should trade up to around 1,200 next year, giving the market another 10 to 15% of upside."

Very interesting. This is the first I've come across the argument that in low rate environments, P/E ratios deserve to be at higher levels. Completely reasonable. Of course, there is the caveat that as earnings rise, so typically would rates, and the P/E multiple would shrink accordingly...good point at any rate.

I'm slowly buying the bullish case. Incredible IMHO, given the run we've already had, but I must agree with Tom Armistead that the defensive names are still trading at attractive lows. I never thought I'd see the day I'd seriously consider blue chips to small caps, but most small caps I've been watching have now priced themselves at fair value with triple digit gains. I suppose it's now the blue chip's turn.

Sep 18 10:59 PM

[Roger Knights:]

"This is the first I've come across the argument that in low rate environments, P/E ratios deserve to be at higher levels. Completely reasonable."

Now consider what will happen to stocks when rates rise, once QE ends, or a few months thereafter. PLONK!

Sep 19 02:15 PM