Wow, it certainly seems like more than five months since fears over a major credit event in Europe were peaking and the market dipped below 1100. Today, the market has risen to 1400 in what has generally been a strong and steady run since mid-October of last year.
In the beginning of the rally, the best performing stocks were big cap tech stocks like Apple (AAPL), IBM (IBM), and Microsoft (MSFT). Later, as the ECB stepped up its liquidity push and the economic data showed the U.S. economy was beginning to recover at a faster pace, banks and industrials joined the market's leadership.
Obviously we all know this now. Still, given that financials, tech stocks, and industrials have largely been the leaders of the rally, I think it is worth looking at these sectors' growth prospects and valuations today. Looking at analyst estimates, company's recent earnings commentary, and the positive but still slow growth we are seeing in the U.S economy, I think the S&P 500 (SPY) earnings are likely to come in between $105-115 dollars this year.
While the market has traded in the fairly wide range of 1000-1370 over the past several years, reflecting the equally wide range of earnings and growth estimates, there are some basic points bulls and bears can agree on.
First, interest rates are likely to stay low for some time. Second, earnings in most sectors are likely to grow at a faster rate over the next 2 years than they did during the previous 2 years. Third, taxes on investment and capital are not likely to rise significantly in the near term. Why is this?
The main reason that interest rates are likely to stay much lower for a longer period of time than in the past, besides a weak economy, is because of the continued difficulty that individuals and small business continue to experience in getting credit. While large companies with strong credit ratings have had no problem issuing short-term and long-term bonds, small businesses and individuals are still having a hard time getting access to credit lines, let alone ones at good rates.
The high debt load that many individuals and businesses still have are another reason why keeping interest rates low is likely to have added appeal for the Fed, even if the economic recovery begins to accelerate. Consumer spending is still the biggest driver of the U.S. economy, and if the consumer has to pay more for credit, it won't help the recovery.
With interest rates likely to remain low long after the economy recovers, it is likely that the Fed will be behind the inflation curve. Fixed income will also likely continue to have muted appeal to all but the most conservative investors in a steady but growth environment, where rates are lagging inflation. Even with growth prospects picking up with recent more positive economic reports coming out of the U.S., the Fed has remained exceedingly cautious in their language, and has similarly all but refused to discuss even the possibility of raising rates in the near-term.
Additionally, the second main reason I believe the market will remain undervalued at 1450 is that earnings estimates are now rising. While there is a healthy debate on whether earnings will grow this year at a single or double digit rate, as the U.S. and global economy continues to recover at a faster pace, earnings will likely continue to grow at least at a modestly stronger rate.
If the S&P 500 earnings come in between 105-115, the current market is likely barely at 14x trailing earnings. Presuming earnings accelerate at least modestly in the back half of the year, the market is likely trading at what is a very cheap historical multiple today.
Also, as earnings accelerate as the year goes on, the market is likely to find itself at less than 13x average estimates for 2013 earnings. If economic growth accelerates going into the back half of the year, the cyclical sectors like the financials and industrials are likely to see the biggest upwards earnings revisions. With leading industrials like General Electric (GE) and Caterpillar (CAT) trading at around 11-12x a very reasonable estimate of next year's likely earnings, valuations seem cheap by almost any historical standard.
Finally, the last additional reason why the market will likely continue to trade at the higher end of its historical price to earnings ratio is because of tax policy. Sure, with Obama approval rating over 50% now, and the deficit still very high, taxes on income and capital gains will likely increase at least modestly for those earning $250,000 or more. Still, I think tax policy will likely stay very friendly for the market.
While upper income earners of over $250,000 a year could see a rise in the capital gains tax from 20-25%, the house is likely to keep a rise in the capital gains tax modest. A 20-25% capital gains tax would be nearly 20% lower than what most upper income earners pay in ordinary taxes on the majority of their income. As an attorney I think it's important to note that any bill drafted to change the tax rates would have to originate in the house under Article 1 of the constitution.
If the capital gains tax is raised to 20-25% on upper income earners, it will likely have little effect on their investment strategy. Also, with the majority of institutional managed money being pension and retirement based funds, most of which are modestly to significantly underfunded, it is unlikely that a modest change in the capital gains tax for higher income earnings will change the strong appeal of equities in a low rate and modest growth environment.
So, what is the market likely to be valued at in the near-term if analyst estimates are within the ballpark of where earnings will come in? Certainly, with growth and earnings estimates still unclear, these numbers are anything but scientific. Still, given S&P 500 earnings are looking increasingly likely to come in the 105-115 range with growth likely to continue to accelerate at a modest but steady pace, I think the market is trading today at roughly 14x 2012 earnings.
The forward multiple of the market based on 2013 earnings estimates is likely in the 12.5 to 13 range. If we consider the historical range that stocks trade in during period of economic expansion as usually between 12-15x forward earnings, the market looks surprisingly cheap today. Additionally, since it is reasonable to presume that interest rates are likely to stay low indefinitely, and with capital gains taxes likely at similarly low levels, monetary and tax policy should continue to be very market friendly as well.
If we consider monetary and tax policy separate from the basic earnings and growth picture, it seems fairly reasonable to think the market should be trading at between 14-15x next years average earnings estimates of $115-130 on the S&P 500. This means the fair value of the market today is likely between 1550-1625.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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