Large Caps Could Lead the Market Much Higher

by: Alan Brochstein, CFA

A few weeks ago, I was participating in a research meeting with one of my clients. The most bullish client in the bunch, who has been that way since May, was trying to make the case that stocks are attractive. While they typically focus on small companies, we were going through big stocks, one at a time. Sure enough, every time we looked at one, it seemed pretty attractive on a PE basis compared to its history. More recently, we were focused on stocks near their all-time highs, some of which happened to also make the list in the prior discussion. As one who has been reluctant to embrace this rally as sustainable, I can't deny what is plain and clear: Big stocks are potentially cheap and technically capable of extending their rallies.

I continue to think that the economy will be challenged for quite some time and that the earnings estimates out there are too optimistic. But what if I am wrong? If rates stay low and earnings recover, what is the upside? What follows is a simple excercise. I took the largest 20 stocks in the S&P 500. Here they are ranked in descending market cap (click to enlarge):

The combined market cap of the top 4% of the index represents about 1/3 of the total market cap of the index. As you can see, the typical forward PE is 15X, though the median for the past decade has been closer to 19. Furthermore, if one looks out two years, the current median PE is about 12 (as earnings are projected to rise substantially in the following year).

In the table below (click to enlarge), I projected the total return for each stock by assuming that a year from now it trades at its 10yr median PE and earns its current dividend. I then added up the total returns by their contributions and, as you can see below, got an astounding one-year return of 53%:

50percent Again, while this is not my prediction, I do accept that PE ratios should be high when rates are low and when earnings are closer to trough than peak. So, if companies hit the projected earnings and multiples rally to median levels, just these 20 stocks could propel the market higher by almost 18% (33% of the market up 53%). I don't believe that smaller stocks wouldn't rally as well - the same dynamics are at work, though perhaps to a lesser extent.

So, absent higher interest rates and/or companies failing to meet projections over the next two years, a reversion to the mean would fuel a massive rally. I have not embraced this potential, but my eyes are certainly open to it. The market made two horrible mistakes earlier this year: Overestimating earnings declines and placing low multiples on trough earnings. Surely we could be overestimating the recovery now, but the multiples are certainly not extreme in the other direction. I found it helpful to look at these stocks one by one. If you click the link below, you can go through the 10 largest stocks and see what the PE history and price history look like. I have included the targets that are derived from the exercise of reversion to the median.

Download Top 10 S&P 500 Stocks

While some stocks don't seem likely to perform as well as the exercise might suggest, others appear capable of doing even better. If the worst is behind us and better times ahead, stocks could have an even better year in 2010 than they have in 2009.

Disclosure: Long JNJ and CVX in a model portfolio