Evaluating Market Level With S&P 500 Having Reached My Fair Value Target

I have written here previously that my personal fair value target for the S&P 500 index was around 1,050. I got there by using an average P/E multiple of 14-15 and projecting a “normalized” earnings run rate for the index of around $70 annually. The index has now risen 60% from its March low and hit a level of 1,074 intra-day on Thursday, about 2% above my target. Naturally, the next question is “what now?”

First we need to reevaluate my initial assumptions to determine if they need to be revised. Current earnings estimates on the S&P 500 for 2009 are about $54, which is a 9% increase from 2008. Estimates going forward are significantly higher than that, at around $73 for 2010. Does my $70 still apply?

In my mind it does. The idea behind trying to determine “normalized” earnings is to eliminate the long tails of the distribution. Valuing stocks based on earnings during a recession ($50-$55) is not very helpful given that the economy grows during the vast majority of all time periods. Conversely, using the previous peak earnings level ($87) factors in a period of easy credit and dramatic leverage which surely boosted profits to unsustainable levels.

So, I would define “normalized” earnings as the level of corporate profits that we could expect in neither a recessionary environment (negative GDP growth), or a highly leveraged economy (say, 4-5% GDP growth). Put another way, what would earnings be if the economy was growing, but not very fast (say, by 2% per year). Something between $50 and $87 most likely, and the number I have been using is $70 for the S&P 500.

Interestingly, the consensus for 2010 is for moderate economic growth, positive but not at the pace we saw earlier this decade. Given that the current earnings estimate for next year is $73, I believe my $70 figure still makes sense, given what we know right now anyway.

Where does that put us in terms of the market? Well, in my mind we are trading pretty much at fair value, but it is helpful to look at both the more bearish case and the more bullish case to get an idea of what the risk-reward scenario looks like. Comparing your potential upside with the corresponding downside should make it easier for investors to gauge how they should be allocating their investment capital.

First, the bears will argue that earnings are being helped merely by cost cutting and that revenue growth will be non-existent because the economy will remain in a rut for a long time. They will contend that earnings in the $70 range for 2010 is overly optimistic and will cite the $54 figure for this year as a more reasonable expectation in the near term. Assign a 14-15 P/E (the median multiple throughout history) on those earnings and you get the S&P 500 index trading between 750 and 800, or 25-30% below current levels.

Next, we have the bulls on the other end of the spectrum. They believe that slow to moderate growth in 2010 is likely and S&P 500 earnings in the $70 to $75 range are reasonable expectations. They go further and argue that given how low interest rates and inflation are presently, P/E multiples should be slightly above average (the argument there being that low rates and low inflation make bonds less attractive and stocks more attractive, so equities will fetch a premium to historical average prices). They will assign a 16-17 P/E to $73 in earnings and argue that the S&P 500 should trade up to around 1,200 next year, giving the market another 10 to 15% of upside.

From this exercise we can determine the risk-reward using all of these arguments. Bulls say 10-15% upside, bears say 25-30% downside, and I come in somewhere in between at a flat market. Therefore, I am cautious here with the S&P 500 trading at 1,066 as I write this. To me, aggressively committing new money to equities at these levels comes with a fair amount of risk given that the best case scenario appears to only be another 10 or 15 percent. As a result, I am holding above average cash positions and being fairly defensive with fresh capital. There just aren’t that many bargains left right now, so I am hoping the next correction changes that.

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5 Thoughts on “Evaluating Market Level With S&P 500 Having Reached My Fair Value Target

  1. Great post Chad, accurately sums up both sides of the argument. I’m cautious as well and probably leaning to the bearish side, although I feel it’s slightly early to really put on shorts of size here. Nevertheless, nothing wrong with taking profits, raising cash, and putting out some hedges.

    Keep up the great stuff, really enjoy reading your work


  2. As I was reading this post I kept thinking, “Wow! This is right on target with the way I think about and analyze the overall market”. Good job Chad!

    As a devoted covered calls investor, now is an especially good time to hedge your long stock positions somewhat by selling some at-the-money or slightly in-the-money call options against your stock holdings.


  3. Great to the point post dude. I’ve been reading many many financial blogs lately in an effort to understand the current rally (I’m a novice). This post contains good info and real analysis.

  4. Where are you getting the earnings figures of $54, $70 and $73? Is there a link someone can provide to get these estimates? I’d like to try using them in my own analysis but am not sure exactly what they are. Any help would be appreciated.

    It seems reasonable to say the market is fairly valued since looking at the Dow Jones stocks there aren’t too many horribly overvalued but not more than one or two good buys. Everything feels sort of in between right now. But, if you factor in market sentiment I feel bulls are still very eager to buy. We are rebounding off of bad news at a quicker than normal pace. If I had to forecast I would think the S&P reaches 1100 before correcting briefly and ending above 1100 by 2010. The average correction has only been 6%, I believe, so I’ll be surprised if it drops below 1000 for more than a few days max. People feel too safe buying at 1000 to let the opportunity go, they’re very confident in the recovery. I don’t know if I am yet.

  5. Chad Brand on September 25, 2009 at 11:34 AM said:

    The Standard and Poor’s web site (standardandpoors.com) has detailed information (including historical and projected earnings figures) for the S&P 500 index. A great resource for S&P data.

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