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The S&P 500 closed at 1146 on 10/01/10, and I believe that it is headed to 1500 by the end of 2011, representing a return of 33% if one includes dividends. While this will prove to be a spectacular move if my call is right, it's really not that spectacular. It will leave us about 31% higher than the market was a decade ago (12/31/01 close of 1148) and it will still be beneath the peak in 2007 of 1576.S&P 500 PE

My call is a valuation call, but it is supported by strong technicals and weak sentiment in my view. The conclusion is predicated upon the following:

  • The economy could just muddle along - it doesn't have to boom
  • PE ratios will rise, but not to lofty levels

If you want to skip the argument and get to the basis for my call, it is simply this: The market will move to 15PE on a forward-looking basis, and the S&P 500 is capable of earning $100 in 2012. Quite simply, 15*100 is 1500.

The Economy is Growing

While I am no economic bull, I have maintained for the last couple of years that the economy will grow despite the challenges, which are numerous (primarily high Consumer and Government debt levels). It's easy to see the negatives of high unemployment, a weak housing market, etc., but there are positives too, like the growth in emerging economies and productivity improvements in the Corporate world. Here is a chart (click to enlarge) of the nominal GDP (real GDP plus inflation). Perhaps you aren't aware, but it's trending up and is at an all-time high:

GDP

It seems reasonable to expect some level of economic growth in the coming years despite all the talk of a "double dip". We don't have capacity constraints. Interest rates certainly don't inhibit the economy. Reasonable people will certainly disagree about the rate of growth, but the onus, in my opinion, is really on those advocating negative growth to make their case.

S&P 500 Earnings Should Grow

The year is more than 1/2 over, and it looks like the S&P 500 will earn about $82. The current outlook for 2011 is about $94. This data is available from S&P itself and is based upon an aggregation of bottom-up estimates provided by Wall Street. The estimates have been pretty stable the last several months. There isn't a 2012 estimate yet, but I am going to go with $100. While it's just 6% growth above the current forecast for 2011 (and would be very disappointing if true), the outlook for 2011 is probably a bit too rosy. My $100 assumes about 10% EPS growth off of 2010 in each of the next two years.

If the estimates are correct, the S&P 500 will have all-time high earnings in 2011 or certainly by 2012. While I don't find that too surprising, some readers may be shocked. The same thing happened in 2005 - four years after the prior "peak" we notched an all-time high. While the plunge was in 2009, it's not surprising given a move to all-time high GDP and a focus on margins that earnings will be at an all-time high.

The PE Ratio is Too Low

The PE ratios are too pessimistic these days. Given the horrific losses of 2008 and the many challenges the economy faces today, it's not surprising that stocks are priced cautiously. Here's the deal, though: The need for long-term investing has never been greater. While there are lots of alternatives to stocks, one of the most obvious is bonds. Some may argue that bonds are in a "bubble", but that's too simplistic. Bonds have done well because they offer reasonable real yields (nominal yield less inflation). While I believe that there could be some risk of somewhat higher yields, they are in the right ballpark most likely. Stocks, though, are extremely cheap to bonds. To demonstrate, I have taken the PE of stocks and inverted it (the earnings yield). Stocks, no doubt, were expensive a decade ago, but they seem the exact opposite today (click to enlarge):

Earnings Yield vs. Bonds
Prior to 2002, the bond yield was between 6% and 8%, while the earnings yield was between 4% and 6%. From 2002-2007, they were more in line with each other (mainly in the 5.5 to 6.5% range). After the blowout in both as the markets collapsed in late 2008, the relationship has been moving more and more the the extreme. The current spread of 3% (8% earnings yield or 12.5PE for stocks compared to 5% corporate bond yield) is extreme.

While I agree that the bond yields could rise, there is a lot of cushion built in. I would expect that as long as it stays below 6%, my thesis of low-inflation growth would probably be intact. What about the earnings yield on stocks? I expect that it will move back towards the bond yield. I am suggesting that it moves to 6.67% over the next 15 months. This would still be relatively high. I believe that there are scenarios that could engender even lower earnings yields. If we go with 6.67%, that suggests that the market PE will be moving from 12.5 currently to 15.0. Hence, 1500 on the S&P 500 (100 x 15).

My case for 1500 on the S&P 500 is simply an argument that stocks are too cheap at 12.5PE in a world of very low interest rates. Even if I am only partially correct, my conclusion justifies a higher allocation to stocks relative to bonds. While I have focused my comments on the S&P 500, I believe that the case is even stronger for smaller companies, which have higher earnings growth potential and should benefit from what will prove to be a spectacular M&A environment. The Russell 2000 peaked in 2007 a quarter ahead of the S&P 500 at a level of 856. Currently at 679, I expect it to trade to an all-time high over the next 15 months, most likely eclipsing 900.

In my Top 20 Model Portfolio, I am focusing heavily on smaller Industrials as the most likely beneficiary of the earnings growth and valuation improvement I project, but I think that Financials could prove to be a real winner as multiples expand. That's an area where I need to do some more work as far as identifying specific securities. Let me know what you think: Will the earnings yields of stocks decline? What's the best way to invest if so?

Disclosure: No stocks mentioned

Source: The Case for 1500 on the S&P 500 in 15 Months