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The Stock Market - Wisdom via Ben Graham

One of my favorite Ben Graham stories is one I cannot substantiate to be true. Nevertheless, it’s a terrific story which I believe contains great investing wisdom.

It was alleged that a young zealous reporter was dogging Ben Graham for an interview. Not one to seek the limelight, Mr. Graham continuously rebuffed him. However, persistence finally paid off and Ben finally agreed and asked the determined young man what he wanted to know.

With great enthusiasm the young man replied, Mr. Graham what I want is for you to share your infinite wisdom about the stock market with my readers. Mr. Graham then gruffly replied:

Young Man, you could have saved us both a lot of trouble by asking the question at the beginning. I can tell you and your readers all I know about the stock market, and frankly, all they need to know about it in two words; IT FLUCTUATES.

The S&P 500 – A Forecast by the Numbers

Ben Graham was a very wise man with keen insights regarding investing. He, like most investing greats, realized that forecasting the stock market is an exercise in futility. However, Mr. Graham also understood how to value a business.

There is abundant evidence and considerable agreement that the value of a business is ultimately derived from the earnings and cash flow it is capable of generating for its stakeholders. Since the S&P 500 (the stock market) is merely a composite of numerous businesses (500), then the same principle for value can be applied to it.

Looking at the S&P 500 through the lens of our EDMP, Inc. F.A.S.T. ™ Graphs (Fundamentals Analyzer Software Tool) validates the valuation based on earnings thesis. In the short run (less than a business cycle, 3-5 years) the stock market obviously fluctuates, as Ben stated. However, over the longer run, a business cycle (3-5 years) or longer, the market’s levels are based on earnings.

Figure 1 below looks at the S&P 500 since 2003 with the stock price (black line) overlaid and correlated to earnings (green line with white triangles). What is evident from this graph is that stock prices follow earnings on a long-term trend-line basis, i.e., a clear visual correlation between earnings and stock prices. Note that the earnings line represents a PE ratio of 16.3 (gold GDF - EDMP 16.3). The blue line is the 20-year historical PE ratio for the past 20 years of 17.5. Note also that the price line rises above and falls below the normal PE ratio line, but inevitably returns to it.

Figure 1 S&P 500 8yr EPS Growth correlated to Price

Click to enlarge:

Figure 1 S&P 500 8yr EPS Growth correlated to Price

It’s important to state that these F.A.S.T.™ Graphs draw themselves based on the mathematics behind them. The lines are not manipulated or made to fit. However, the normal PE ratio of 17.5 shown is the average for only the past 20 years. This includes the irrational exuberant period from 1997 through 2002 as illustrated by Figure 2 below (pink shaded area). This aberrantly overvalued time period skews the number. The normal PE ratio for the S&P 500 over the past 80 years is closer to 15.

Figure 2 S&P 500 20yr EPS Growth correlated to Price

Click to enlarge:

Figure 2 S&P 500 20yr EPS Growth correlated to Price

Overtime the price of the market will trend where earnings trend. Keep in mind that earnings are only reported quarterly. The stock market is an auction and trades daily. Therefore, reactions to every piece of news the media can conjure up causes short-term volatility. However, over time true value, which is based on mathematical principles of return as a function of earnings and cash flows, ultimately manifest. In other words, earnings determine market price in the long run.

Figure 3 below goes back to the 8-year view but adds a valuation flag for 12/31/2010. Based on the current median consensus estimate from FirstCall for earnings of $75.37 (yellow circle) for the S&P 500 for 2010 implies a normal year-end value of $1,318.98 (see yellow box on figure 3). In other words, multiply the estimated earnings of $75.37 times the modern historical normal PE of 17.5 and you get a S&P value approximately 20% higher than today. So to be clear, instead of a forecast, this is a mathematical calculation of the S&P 500’s year- end value based on earnings estimates capitalized at modern PE norms.

Figure 3 S&P 500 8yr EPS Growth with Value Flag

Click to enlarge:

Figure 3 S&P 500 8yr EPS Growth with Value Flag

Conclusion

Last week the market showed weakness and the doomsayers came out of the woodwork. As previously stated, this article is not a forecast, rather a simple calculation of what the market would be worth at year-end 2010, assuming earnings forecasts are accurate and normal valuations are achieved.

According to a Reuter’s report on February 12th,2010, 73% of the roughly 380 S&P 500 companies already reporting for year-end 2009 have beaten estimates. Therefore, it’s safe to say that so far so good as we enter 2010. On February 8th, MarketWatch Pulse reported that Bank of America Merrill Lynch (BAC) raised its earnings forecast for the S&P 500 Index to $75 from $73. They also raised their 2012 number to $90 a share. There was also an interesting article in Barron’s on February 15th by James Paulsen, Chief Strategist for Wells Capital Management that makes a compelling case for optimism. So, multiple sources are corroborating 2010’s S&P 500 earnings forecast.

Therefore, our point is simple: If the economy continues to improve, given the leverage from the leanness many U.S. companies possess today, earnings growth could be strong. Therefore, there is no reason to expect the market not to capitalize those earnings at normal valuations. If true, then we may have another year or more of good market returns. We choose to be optimistic; it just feels better.

Disclosure: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclosure: No Positions

Source: S&P 500: A 20% rise in 2010?