Our current assessment is that the US stock market averages (based on S&P 500 index) are slightly undervalued, yes undervalued, taking into account the most recent expectations for future earnings growth and Federal Reserve interest rate policy. This is a change from previous forecasts where the expectation was for earnings to decline given a slowdown in economic growth, thus causing the US markets to decline. While a slowdown in economic growth did occur and markets did decline over the summer on the expectation of a decrease in corporate earnings, the slowdown apparently didn't impact corporate profits, as earnings estimates have not declined since the end of last quarter.
Surprisingly, earnings estimates have continued to move higher over the past few weeks, an indication from analysts that despite a slowdown in growth companies are still able to produce an increase in profits, most likely do to operating efficiencies and continued cost cutting.
As of October 1, earnings estimates have increased from $81.73 at the end of last quarter to $82.69 for the 2010 calendar year. Earnings estimates for 2011 decreased a few percent to $93.93, which assumes growth of 13.5% over 2010 numbers. Using a price-earnings multiple of 15 (long-term average valuation proxy), we calculate valuations of roughly 1,240 for the S&P 500 Index for 2010 and approximately 1,400 for 2011, above current index levels of roughly 1175. Remember, the markets tend to follow earnings and not economic growth. So even though economic growth may be weak, it seems corporations have been able to sustain and even increase earnings through continued cost cutting in conjunction with productivity gains.
In the first few weeks of the third quarter earnings season, corporate profits are coming in better than expected so it is possible earnings estimates are not inflated as originally thought. As long as reported earnings are generally positive during the quarter and future guidance is upbeat, we should expect the markets to continue to move higher, at least in the intermediate term.
