Reversion to the mean is a powerful concept and one that argues that the S&P 500 is currently fair-to-over valued based on long-term earnings trends. However, trends tend to defy logic and the S&P 500 would likely require an external shock in order to "efficiently" re-price itself to more attractive levels. Overtime, however, gravity will likely exert itself and I expect little upside at the current valuation.

S&P 500 (NYSEARCA:SPY) earnings expectations for 2013 are for $103.18 (as reported, top down estimates) based on the most recent data from S&P. Assuming a 2.5% inflation rate, this is equivalent to forward real earnings of $91.61 in 2012 and $98.86 in 2013. This reflects real earnings growth of 3.9% in 2012 and 7.9% in 2013. (The 10-year average earnings would correspond to $66.95E and $72.18E for 2012 and 2013, respectively.)

The following figure graphs the long-term real earnings compared to both the 10-year average and the long-term trend line based on the earnings growth rate (1.7%). I have also included in the box to the right the current real earnings estimates for 2012 and 2013 (assuming a 2.5% inflation deflator.) Assuming a recent PE of 15.6X, a 2013 S&P500 target would be roughly 1,540, a 10% increase from current levels.

Figure 1

Since 1926, real earnings growth has been 1.7% annually. (I would argue that the 1.7% growth rate is likely high and more realistically in the 1.4% range. Note that the real GDP per capita long-term growth rate in the US has been ~1.9%, which should be a ceiling for trend line corporate profit growth).

With current real earnings running at 40% above the 10-year average, I view that mean reversion will at some point pull earnings down to the long-run average **which is contrary to current estimates**. In other words, real growth of ~8% in 2013 is a low probability outcome in my opinion.

On a mathematical basis, with earnings at current levels, the 10-year earnings average will accelerate as trough earnings of 2002 roll off. This will put the 10-year average earnings squarely above the long-term trend (regardless of moderate +/- swings in near-term growth rates).

If one assumes that the current earnings growth rate slows to the long-term trend line growth of 1.7%, then 2013 real earnings might be more realistically at approximately $93E. As you can see from Figure 2, the 10-year average continues to rise despite the slowing of earnings. Assuming no PE expansion and a 15.6X multiple, the 2013 S&P 500 target would be 1,450 which is slightly above current valuation.

Figure 2

While the market is aware of several potential shocks, we can't know for sure what will happen (and why I favor trend following systems in the first place.) However, based on a recession or shock related impact (or both), a decline in 2013 earnings "fits" better with history and likely a more reasonable reversion to the mean outcome. For scenario purposes, using a decline to $80E in 2013 and a 15.6X multiple reflects an S&P 500 price target of 1,250. This is below current levels and near levels at the beginning of the year. Figure 3 highlights a reversion to the mean scenario.

Figure 3

Based on the above scenarios, I can see valuations from 1,250 to 1,500 assuming no material changes in valuation multiples. Clearly a recessionary environment would push a multiple downward and making a sub 1,000 S&P 500 target not unreasonable.

So what do? Based on the intermediate trend, the S&P 500 has been above its 10-month moving average since the beginning of January (7 months). At yesterday's closing at $140.49, the SPY stands at 5.0% above its trend which is below its long-term average of 6.4% (when above trend), which indicates valuations are not stretched on a relative basis. Therefore, I continue to hold positions in SPY and other large cap domestic equity ETFs such as the Russell 1000 Growth (NYSEARCA:IWF) and Russell 1000 Value (NYSEARCA:IWD).

However, tactically I am cautious with entering full positions at this point based on the powerful impact of reversion to the mean. The fundamental back drop is not one of optimism and creates a compelling narrative for reversion to the mean in earnings. Furthermore, at current price levels and the possible 1,250 to 1,500 price range, I believe the S&P 500 has little upside (or inversely - little margin of safety.)

Figure 4