S&P 500: Valuation And Outlook

Includes: JNJ, MDT, PG, SPY, SYY
by: Disruptive Investor

In the last three years, the S&P 500 index has surged by 98.5% from its March 2009 lows. If one looks at the rally in parts, the following happened:

From the March 2009 lows of 676, the index surged by 65% in the next nine months to close the year at 1115. Considering the strong upside in 2009, the S&P 500 clocked decent gains of 13% for the year 2010, with the index at 1258 by the end of the year.

The following year (2011) was more challenging for the index, with the S&P closing the year almost at the same levels of 1258. The index has gained 7% for the year 2012, but is almost at the same levels as it was in February 2011. In other words, the U.S. markets have been moving sideways for nearly 16 months.

Therefore, after the initial surge from March 2009 lows, the markets have been largely sideways. There might be two probable reasons for markets exhibiting such behavior -

1) Markets are fairly valued based on current earnings

2) Market participants are unsure about the state of the economy and earnings, and the sideways movement is indicative of this confusion

The latter seems more true in the current market scenario.

S&P 500 ten year chartClick to enlarge

This article discusses the market valuation and the near to medium-term outlook for the markets.

Before I discuss the PE valuations, it is worth mentioning that of the 120 S&P index companies, which have reported second quarter earnings (as of July 19, 2012), 82 companies beat estimates, while 21 have missed estimates. The remaining 17 companies have met estimates.

These are good numbers. However, I have doubts over a repeat of this performance in the third and fourth quarter of 2012. The economic slowdown globally will take a toll on earnings in the next 2-3 quarters.

Coming to the PE valuation, the market is currently trading at nearly 14 times the TTM operating earnings per share.

S&P 500 PE chart since 1988Click to enlarge

I believe that the markets are not overvalued. Rather, the markets are trading at 11.5 times the estimated 2013 earnings. The PE valuation of 11.5 is the lowest since 1988. Therefore, one can say with some conviction that markets are fairly valued or undervalued.

As mentioned above, the critical point to consider here would be the impact on earnings for corporations in the next few quarters due to the global slowdown. It has to be understood that many S&P 500 companies are global companies, and a global slowdown in bound to impact earnings in the next few quarters.

The current 2012 operating earnings per share estimate of USD102.9 and the 2013 estimate of USD116.48 look optimistic, and will be revised downwards in the coming quarters. Therefore, the PE valuation will look relatively less attractive than it is now.

Also, in my opinion, the US corporate profit after tax, which has surged to record highs, has seen a near-term peak.

US Corporate profit after taxClick to enlarge

Having said this, I am not ultra bearish on the S&P 500 index outlook for the medium-term and even the long-term (next 3-5 years).

If the US economy slows down very meaningfully and the probability of a global recession increases, it would not be surprising to see the S&P correct by 10-15% from these levels. A stronger dollar is indicative of contracting global liquidity and supports the theory of a near-term correction in the markets.

Any such correction will make valuations attractive, with the PE coming down to 12-13 times the financial year 2012 earnings. I would consider this a good entry point, because I am sure that if markets correct by 10-15%, policymakers will get back to action. More quantitative easing would be positive for the markets, especially when valuations are attractive and US corporates are dynamic.

Therefore, I personally don't expect the S&P to crash or go anywhere near the March 2009 lows in the foreseeable future. On the contrary, the US markets might outperform the emerging markets in the next 6 months to one year.

It is difficult to talk more about short or medium-term targets for the markets. In my opinion, that is an impossible task. Therefore, from an investment perspective, I would look to consider fresh exposure to the index on correction in the next 3-6 months.

I talked about sideways markets at the beginning of this article. If this trend does continue, investors would be better off in accumulating high dividend yield stocks besides index investing.

My investment suggestions would be -

Investing in the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) with gradual accumulation on corrections

Investing in some quality dividend aristocrats (25 consecutive years of increased cash payments based on ex-dividend dates from January 1 - December 31 of each year). I would personally consider healthcare and consumer staples industry to select the dividend aristocrats.

1) Sysco Corp. (NYSE:SYY)

2) Procter & Gamble Co. (NYSE:PG)

3) Johnson & Johnson (NYSE:JNJ)

4) Medtronic, Inc. (NYSE:MDT)

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