Stock Market's Rise Is Supported by Values, Not Speculation

Feb.16.11 | About: SPDR Dow (DIA)

A product’s value determines its price. For the stock market, that value has risen appreciably over the past 18 months. Small wonder, then, that stock prices are up likewise. Here’s the picture …

A word about estimated earnings

Stock valuations are based primarily on estimated earnings. However, some investors are wary of using these future forecasts. They have seen actual earnings vary widely from the estimates. In addition, the estimates themselves can shift over time.

However, these are not reasons to ignore the estimates. The variability and uncertainty are the risks associated with investing. Investing success depends on capturing future returns. That means forecasting the future is critical.

Even when making decisions using current or past information (e.g., dividend yields, payout ratio and dividend history), investors still make forecasts -- that the past is an indicator of the future. However, if future earnings fall, dividends (and any other measures) are put in jeopardy. So we are back to the importance of estimated earnings.

The key observation: The stock market is up, but valuations are not

Here are the past 18 months of earnings estimates alongside the DJIA. The dates chosen are primarily mid-quarter, capturing the effect of quarterly earnings reports.

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Note that there are two earnings growth factors:
  • Growth of 2010 estimated earnings from August 2009 = 14.9%
  • Earnings growth rate from 2010 to 2011 (current estimates) = 11.7%
Compounded, these two growth rates = 28.3%. Over the same period, the DJIA has risen a near-identical 28.6%, meaning the price/earnings (P/E) ratio is unchanged at 12.8 (7.8% earnings yield).
Annual valuation comparisons actually show a lagging DJIA rise
Here are the past 18 months of P/E ratios, using 2010, 2011 and 2012 earnings estimates.
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Note that since last spring, the P/E ratio has declined from about 13.8 (times 2010 estimated earnings) to 12.8 (times 2011 estimated earnings).
So, based on estimated earnings, the DJIA valuation has not risen over the past 18 months. If anything, it has slipped. Therefore, the stock market's gains do not indicate increased speculation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Client positions: Long U.S. stocks and U.S. stock funds