S&P 500: Modestly Overvalued

| About: SPDR S&P (SPY)

After a strong price recovery in 2009, the question on every investor’s mind is what about 2010? To us, it’s always a function of valuation based on earnings. In fact, the correlation between earnings and price explains a lot about past, present and ultimately future performance. This is true for individual companies, but applies to indices as well.

In Figure 1 below we look at the S&P 500 since calendar year 1996. This is just before the infamous irrational exuberant period that ended in 2000. Note how dramatically overvalued the S&P 500 had become. The black price line should be touching the earnings line at the 20-year historical normal PE ratio of 17.5. As can be seen the inevitable reversion to the mean occurred as price fell to earnings justified levels.

After the correction occurred, the price action of the S&P 500 has closely tracked and correlated to earnings since 2003. The price following earnings is what one normally expects to see. Therefore, the importance of earnings is evident and, in our view, profoundly important.

Figure 1 S&P 500 15yr EPS Growth Correlated to Price
S&P 500 15yr EPS Growth correlated to PriceClick to enlarge

Price Follow Earnings

What we conclude from the above is as follows: Note that the stock price of the S&P 500 ended above its 2009 earnings justified level at a closing PE ratio just above 19 (red circle). This is slightly higher than the last 20-year average PE ratio of 17.5, and above the 80-year average S&P 500 PE ratio of 15. However, also note that the current S&P 500 stock price is lower than earnings estimates for year-end 2010 justify. The bottom line is that we believe the general stock market today is modestly overvalued.

On the other hand, a 20-year historical normal PE ratio of 17.5 times 2010’s estimated S&P 500 earnings of $73.50 implies an S&P 500 fair value of 1,286.25 by year end. This is obviously above its current value at close of business on 1/4/2010 of 1,132.99.

Therefore, assuming the forecast is reasonable, the S&P 500 has only modest upside for calendar year 2010 based on normal valuations.

On the other hand, there is not a great deal of risk in the index either. Once again, this hypothesis is based on the 2010 earnings forecast being reasonably accurate.

In the Final Analysis

We believe that understanding and recognizing the relationship between earnings and price is vital to long-term investing success. When price is above what earnings justify, caution is called for. However, when price is below what earnings justify, opportunity is usually manifest. In the long run earnings determine market price.

Today’s article is based on the S&P 500 considered a good proxy for the market in general, also referred to as the averages. In future articles, we will feature strong above-average individual companies that we believe remain undervalued opportunities.

We contend that it is a market of stocks rather than a stock market. Therefore, focusing only on what the market in general may or may not do can be very distracting for investors. What you actually invest in is ultimately more important than what the averages may do. We suggest seeking out above-average businesses at or below fair value as a formula for successful investing.

Disclosures: No positions