As we approach the 1250 area on the S&P 500 which I have been targeting since this summer and the market pushes into a short-term overbought situation, it becomes tempting to take some chips of the table. I succumbed to similar thinking in June 2009 after the market had soared from the lows. Thankfully, I have stayed bullish subsequently and will be very careful to keep my eye down the road, as I think that we have further to go. Yes, the next few weeks or even months could prove frustrating as the market consolidates the recent advance or as some high-flyers run into sellers on January 3rd (a new tax year), but I continue to suggest that we are heading to 1500 in 2011.
I described my thinking in early October, forecasting continued earnings growth but suggesting that the majority of the rally would be from expansion of PE multiples. As we contemplate the future, it's always helpful to consider the recent past:
- 2007: Margins and Sales peak, with multiples starting to contract
- 2008: Margins and Sales evaporate, with multiples also moving to multiyear lows
- 2009: Margins and Sales (at least the forecasts) begin to come back, PE ratios stay low
- 2010: Margins and Sales expand, but fear of the double-dip keeps PE ratios low.
What drives the PE ratio? That's a great question that is ultimately not known, as there is no requirement that buyers and sellers disclose their motivations or expectations. The answer ultimately is supply and demand. With that said, most of us would probably agree that the rate of interest and the growth in earnings are key determinants.
Before we assess supply and demand, let's briefly look at the two key determinants. Interest rates have been rising recently, at least intermediate and longer maturities. Nevertheless, rates remain very low. Investors are becoming more aware of the valuation discrepancies between corporate bonds and stocks. The current PE on the S&P 500 is about 13, which is roughly a 7.5% earnings yield. Historically, the earnings yield of stocks has been at a discount to the corporate bond rate, but that level is currently just 5.5%, which is actually slightly lower than a year ago. Believe it or not, the forward PE on the S&P 500 was 13 a year ago as well. That get's us to the "growth" aspect.
Operating Earnings growth for the S&P 500 will end up being some huge number for 2010, but it's not that different of a number than what the market was expecting a year ago. For 2011, the current consensus is that earnings will grow 13%. Thus, it's not that surprising that stocks are up about 13% considering my statement that the PE ratio is essentially unchanged this year. If you are following along, what stocks do in 2011 will be a function of where investors expect earnings to be in 2012. I don't want to lose anyone on this point, so let me repeat: The market looks ahead by about a year. So, part of next year's return will be what the consensus earnings will be for 2012 in a year, while the balance will be determined by dividends paid (about 2% of the return) and the change in the PE ratio.
As I think about 2011, the earnings growth might not be as strong as the analysts are currently forecasting. Maybe it's just 10% instead of 13%. Currently, the S&P 500 is supposed to produce earnings of 83.61 in 2010 (according to Standard & Poors, which aggregates analyst estimates) and 94.48 in 2011. I am not enough of an econometrician to project exactly how this plays out, but we are early enough in the cycle that we should be able to do compound growth of at least 8-10%. If I take the 83.61 and grow it at 10% next year and 8% in 2012, that gets us to 99. If I put a 15PE on that, we get real close to the 1500 target I maintain.
Is 15PE reasonable? I think so. It accommodates a likely rise in corporate bond rates. In fact, I envision a potential rise of about 100 bps, which would be about 6.5%. If we invert 15, we get an earnings yield of 6.7%. Parity, roughly. Over the past decade, the forward PE has been a median of 16, so 15 isn't out of the norm, just a modest expansion.
So, what about the real drivers of the PE: Supply and Demand? So far, we aren't seeing an inundation of primary supply (new equity offerings). Even when we do see it, like the recent GM offering, it is easily absorbed. It would seem to me that the real swing factor will be demand. In 2010, we saw a resurgence in strategic M&A as well as the return of private equity LBOs. Granted, they aren't like the "good old days" in terms of how much leverage is permitted, but it's placing a floor underneath the market. I have discussed previously that pension funds and other long-term investors should be increasing allocations to stocks given the valuation relative to bonds. Funding gaps between assets and liabilities remain high. Finally, companies are generally flush with cash and will likely continue to repurchase stock, perhaps more aggressively given the improving sentiment.
Let's face it: We all have feared having the proverbial rug being pulled out from under us over the past 18 months. The events of 2008 and early 2009 were so devastating that it is natural that what appears to be a rather normal recovery following a rather abnormal plunge and quick initial recovery could be so doubted by investors. As we move further away from the past and investors become more comfortable about the future, I think we can get the slight PE expansion I predict, even if we get some headwinds from rising rates. As you can see in the chart beneath, the economy is back to all-time highs (nominal GDP), and that's just our tired old economy and not some of the more exciting geographies of the world:
So, 1500 S&P 500 is where we are most likely headed if the blue lines above do what they have done for many years and just keep rising. We get this 21% return primarily from PE ratios reflating to levels consistent with low interest rates, even if they rise moderately. Going from 13PE to 15PE produces appreciation of 15%, with the projected earnings growth in 2012 making up the balance. If you really think about, it's not a heroic call.
Disclosure: No stocks mentioned