Our assessment is that the US market averages (based on S&P 500) are still at the higher end of fair valuation, if not slightly overvalued, based on final earnings estimates for 2009 ($56.86) and current estimates for 2010. However, valuations don’t seem to matter as the markets continue to power higher on expectations of a stronger economic recovery and increased corporate profitability.
As of January 1, 2010 earnings estimates for the S&P 500 stood at $75.27 for 2010, representing a 32% increase over finalized 2009 results. As of April 1st, earnings estimates have increased to $78.15, a 37% increase over 2009. A 15 price-earnings multiple (long-term average valuation) on the $78.15 estimate translates to a 1,172 value for the S&P 500 Index. Given the abundant liquidity in the markets, low interest rates, and expected low inflation, market participants could put a premium on future corporate earnings and be willing to pay more for those earnings; pushing markets significantly higher. For example, placing price-earnings multiple of 18 on earnings of $78.15 translates to a 1,406 value for the S&P 500; while a multiple of 20 would put us back to the old market highs reached in 2007. We can’t rule out the possibility, if economic conditions remain favorable, of the markets moving back to new highs over the next couple of years.
However, as we have stated previously, while we do believe earnings will increase in 2010, a 37% increase is probably a bit optimistic. We will likely need to see double digit GDP expansion in order to see such an increase in earnings. While this type of increase in earnings may not happen; it’s the perception of what may happen that matters. Right now the perception is that earnings will increase significantly and the economy will continue to accelerate with or without job creation. As long as this perception holds weight with market participants, the markets will likely continue to climb as this outcome is priced into stock valuations.
