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A Realistic Market Valuation Forecast.... Uh-Oh

With 88% of the S&P 500's Q4-2009 earnings now in (and now that Standard & Poor's has updated their marketwide outlooks through 2011), we've got more than enough data to reassess where the market's likely to be headed over the course of this year. Let's just say it's a mixed bag.

Assuming the S&P 500 were a company and not just an index, we can assign it all sorts of company-like attributes. The two we're most interested in are earnings per share (the index itself acts as one share), and a P/E ratio. With just these two simple measures, we can actually do quite a bit in the way of assessing the market's health and making a reasonable price forecast. 

A couple of housekeeping items first though, just to set the stage..... 

The Good 

Earnings are indeed getting better - this is undeniable. Now that nearly 90% of the companies in the S&P 500 have reported earnings, we know that the S&P 500 itself will 'earn' about $17.34 (operating) per share for Q4 of 2009. On a GAAP or reported basis, the S&P 500 will earn about $15.72 per share. 

Just for perspective, those figures were -$0.09 per share and -$23.15,respectively, in the fourth quarter of 2008. Each has gotten sequentially bigger since then. 

As of Wednesday's closing price of 1105.24, the S&P 500's trailing-twelve month operating P/E is 19.47, and its equivalent GAAP or reported P/E is 21.45. For comparison, the long-term averages of those numbers are 19.40 and 26.18, respectively. (Those averages are marked by red and green dashed lines, respectively, on the accompanying charts.) 

Better still, both earnings figures are expected to at least hold flat or continue improving this year and next. Standard & Poor's is looking for an operating EPS of $21.26 in the fourth quarter of 2010 ($77.72 for the full year), and a GAAP EPS of $14.48 in the fourth quarter of this year ($58.46 for the full year). That translates into a 2010 P/E of 14.21 and 18.90, respectively. 

So what's the problem? Comparing the projected P/E ratios to the long-term average P/E ratios says stocks are undervalued by anywhere from 19% to 27%. Based on those numbers this is a no-brainer - get in the market and enjoy the ride, right?

The problem is timing. Keep reading. 

The Bad 

The funny thing about 'averages' when it comes to the market... the data in question spends much of the time above the average or below the average, but very little time at the actual average itself. And yes, this applies to the S&P 500's P/E ratios. 

The reality is - and this is at the core of what could hold stocks back in 2010/2011 - the P/E ratios in post recession environments like the one we're in now tend to be at the very low end of the typical P/E range. Historically speaking, P/E ratios tend to sink until we're about at the midpoint of the market's post-recession growth phase. We saw this coming out of the 2001 bear market as well as when we were coming out of the 1990 bear market. (Click here for that full-screen perspective.) 

So what? The 'so what' is that while stocks may be priced and/or headed to lower than average pricesrelative to earnings, they may already be priced appropriately at this point in the cycle.... which is the second year of the recovery. 

Said another (more direct) way, anyone assuming stocks will price themselves according to the normal operating and GAAP P/E ratios of 19.4 and 26.18 by the end of 2010 may be sorely disappointed. Stocks may already be at or near their maximum valuation for this stage of the cycle. 

Historical Perspective 

To add some detail to the warning, following the 2001 bear market, the S&P 500's operating P/E ratio didn't bottom at 15.55 until the middle of 2006... more than three years after the index itself had hit its ultimate bottom.Its operating P/E ratio didn't bottom at 14.47 until late 1994 following the 1990 bear market... four years after the market began to move higher again. (Click here for the entire P/E ratio history for the S&P 500.) 

Do you see where this is going? If history is any indication, we should expect operating P/E ratios to drift towards 15.0 in 2010 - not the normal 19-ish - as we enter only our second year of the recovery phase. 

Based on that P/E and the previously-discussed earnings forecast, it would be hard to say the S&P 500 will be worth much more than 1165 by the end of the year - about 5.5% higher than its current trading level. Applying the same math on a GAAP/reported basis suggests the S&P 500 will actually be worth less by the end of 2010 than it is now. 

None of this is intended to frighten you. In fact, you shouldn't be frightened at all - the market is recovering. Moreover, the forecast can be adjusted between then and now (though they're rarely significant adjustments). 

Our only intent is to encourage investors to recognize that what the market considers to be an appropriate price is always changing. Here in an environment where investors are still a little shocked and worried, it's much tougher for stocks to justify frothy valuations. Indeed, history says theywon't... at least not for a while. 

Bottom Line 

In simplest terms, these numbers are a recipe for mediocrity (at best) for 2010, and perhaps beyond. That's not inherently troubling unless you're a true buy and hold investor. See, the odds are very much against a broad market tide rising and lifting all boats with it in 2010. History tells us so. 

The secret to sustaining 2009's progress into this year is focusing on the best of the best sector, industry, and stock trends, and being pro-active with them. Yes it's a little more work, but it beats a wasted year.

Disclosure: NA