Valuation

Based upon Q4 earnings reports rolling in, Zacks estimates that SPX earnings for 2010 will come in at about $83 per share. At the begining of 2010 the average forecast for SPX earnings was $77 and I heard several pundits warning about how they believed analysts were "too optimistic". Well, turns out they weren't optimistic enough which in bull markets tends to be the norm. Do you remember in 2008 how every quarter analysts always over estimated earnings even though they were slashing them day by day? They were never pessimistic enough!

Let's put this latest earnings figure into perspective. The highest annual EPS ever recorded for the SPX was about $88 in 2006. The market is now poised to smash this record in 2011 with EPS estimated to be $95 for the year. If that ends up being the case where do you think the market will trade at? If the market has record earnings don't you think it should trade at record highs? It's seems logical to make such a conclusion but you have to consider other factors. For instance, the last time the market was at record highs was it "justified" to be at such highs? If not, then using that previous high as a benchmark is not appropriate.

In 2000 the SPX made a peak at around 1550 as it did in 2007. Earnings in 2000 was about $56 which gives you a p/e of about 28.....clearly excessive. In 2007, when the SPX also peaked at about 1550 it had much higher earnings that time around which was $82.50. That gives you a p/e of about 19....not off the charts excessive but historically high. How about now? Based upon current forward earnings, the p/e of the market is 13.7. That's not excessive by any means. Even if the market was trading at the all time high of 1550 it would have a p/e of about 16 which is a little above above the historical average of 14. Then there's the interest rate factor. The lower the level of interest rates (I'm talking about long bond yields here, not the fed funds rate), the more "justified" a higher p/e multiple for stocks is and so therefore, the fair value p/e for stocks should be adjusted for interest rates. With interest rates as low as they are now, it makes the market look even cheaper...even if rates go up another 1% or so they would still be historically low and stocks would still be attractive on a relative basis. However, there is a major flaw with the interest rate adjusted valuation method - the so called "fed model". Lower trending interest rates could be a reflection of the market's expectation for a weak economy and if that turns out to be true, future EPS for stocks would likely contract significantly and therefore stocks wouldn't be attractivily valued as they appeared to be. This is what happened in 2007-2008. Stocks were still considered undervalued according to the fed model when they peaked. This made a lot of bulls out there complacent.

The fed model is currently suggesting stocks are still considerably undervalued but this time around I don't think it's giving a false signal because for the past 2 years interest rates have been low and earnings have been rising sharply. Thus, low interest rates this time around have been a reflection of high risk aversion and low inflation due to excess capacity and not an omen of declining economic activity.

So, all in all, it appears as though the market is undervalued to fairly valued assuming that earnings will be what they are expected to be and don't be suprised to see earnings come in better than expectations yet again. I realize that valuation is subjective and pundits bicker about it with each other to no end. Market valuation also tends to make people victims of dogma. They tend to think that their method is "right" and that the market is going to adhere to their view and magically stop rising or falling when such and such valuation parameters are hit. And then of course, they get run over when it doesn't happen. That's why when it comes to valuation it's not the primary driver of my decisions because nobody can know for sure what "fair value" really is and even if you did, the market tends to overshoot and undershoot fair value and can do so for prolonged periods of time.

I wanted to talk about valuation because although is argueable as to what fair value of the market actually is, the evidence says that the market has just about as much earnings backing it up now as it did when the market was at an all time high of 1550 about 4 years ago, plus interest rates are notably lower now making todays earnings more "valuable". Therefore, at 1300 it's not a stretch to envision the market going up another 20% from here within 1-2 years. And if earnings end up making new all time highs in 2011, it's not a stretch to envision the market making new all time highs within 1-2 years especially with LT sentiment conditions also supporting the notion that the market has more room to advance before people are truley "too bullish".