|S&P 500||Earnings||E10||LT10iYield||PE Bonds||PE10 Stocks||PE Stocks||PE:Bonds/ PEStocks10||PE:Bonds/ PEStocks|
The US stock market likely has more in it in 2010 based on earnings estimates and after allowing for lower actual outcomes and higher interest rates, but ensuring that valuations using PE's and Robert Shiller's PE10 remain somewhat conservative to reflect uncertainty.
If severe inflation is a worry then long term bonds are not a safe place as rates rise to fight inflation, causing a reduction in market value and devaluing the principal amount in the future. Whether commodities, precious metals or stocks are a better hedge than being in cash in the short term as rates rise is beyond the scope of this article.
Stock price valuations take into account earnings and alternate investments such as bonds.
S&P current earnings estimates for 2010 are about $79. The earnings column above has a range of different earnings assumptions all for 2010
A reasonable benchmark for the sustainability of current earnings is the Robert Shiller 10 year average real earnings. Average real earnings grow at about 1.5 to 2.0% pa and the long average reduces the impact of business cycles. If earnings are significantly above the average, investors might be cautious about applying a high 1 year trailing PE ratio. If earnings are very low the trailing PE ratio might be ridiculously high as in December 2008. So we watch two PE ratios, one based on the 10 year average real earnings and one based on last year's earnings. These are shown in the columns PE10 Stocks and PEStocks respectively.
As earnings change, so will the 10 year average used by Robert Shiller of Irrational Exuberance fame. The E10 column represents guesstimates of E10 at end 2010 depending on the actual earnings outcomes over 2010
We know that interest rates are sensitive to the economic cycle at the short end and to inflation and the stage in the business cycle at the long end.
PE ratios need to be considered in the light of inflation, alternative investments and sustainability of earnings. A commonly used alternative investment is bonds and LT10Yields is my guess for how 10 year interest rates might vary depending on how the economy improves measured by the earnings outcome for 2010. If earnings are subdued bond yields might increase only marginally. If earnings grow substantially there is likely to be more pressure on interest rates, mainly at the low end, but also at the middle terms. Those yields can be converted into PE ratios for bonds as in the column PE Bonds.
To take into account the way bond yields have varied with changes in the rate of inflation to the 1984 peak in rates and the declining trend in rates and inflation from then to now we can compare the PE's of stocks to the PE's of Bonds and compare the historical ranges of the ratio. This compensates for the changes in long term interest rates and PE's resulting from long term changes in the rate of inflation.
The 40 year median of PE Bonds divided by PE10Stocks is 0.861.
The 40 year median of PE Bonds divided by PEStocks is 0.864.
While the 40 year median of the PE is 17.2 the values have ranged from as low as 7.0 in 1979 to a high of 123.7 in May 2009 (both calculated based on Shiller's spreadsheet from his Irrational Exuberance site
The 40 year median of the PE10 is 17.4. The low was 6.64 in July 1982 when LT10 interest rates were 13.95 with a resulting PEBonds of 7.16. The ratio of PEBonds divided by PE10Stocks was 1.07. This ratio varies much less than the PE ratios as it reduces the effects of differing levels of inflation and simply compares the earnings and price of these two alternative investments.
In the 2008 crisis The yield on bonds was low (about 2.5%) and the calculated PE was high (40). For stocks, because of the collapse in 2008 earnings the PE of stocks was very high (around 100) but the Shiller PE10 fell from 27 in Sept 07 to 13.55 in March 2009.
Now that things are normalising, (albeit at lower levels of activity particularly until surplus housing stock is reduced, job security increases, un/underemployment falls and house prices rise with some consistency) we can look at the prospects for the markets at the end of 2010 taking into account earnings, interest rates and historical ranges of PE and PE10.
Because investors are now more concerned about potential volatility on the downside of stocks I have assumed
a) required ratio of PE Bonds divided by PE10Stocks of around 1.2 even though stocks are historically cheap at a ratio greater than 1.
b) a requred ratio of PE Bonds divided by PEStocks ranging from 1.13 at lower earnings to 0.87 at higher earnings on the basis that confidence will increase if earnings are higher, even though stocks are historically cheap at a ratio greater than 1.
It is possible even likely that there will be further gains over 2010, although the pace of gains will be substantially reduced from those of 2009.
If things go well in 2010 there could still be significant gains in 2011 as the acceptable PE and PE10 ratios to the the bond PE reduce as investors could become more concerned about missing out on gains and less concerned about downside volatility. Again the rate of gains would not be like 2009.
However if consumer deleveraging continues, government support reduces and house prices fall during the Alt-A resets then the outlook is neutral to negative even at todays level of around 30% below the 2007 peak.
Acknowledgement Robert Shiller: Data: www.econ.yale.edu/~shiller/data/ie_data.xls
Disclosure: Long: AUS bonds, emerging markets, commodity stocks, Australian stocks, international stocks, AUD, Australian real estate
Disclosure: Long stocks, bonds, AUD, Australian real estate