General Market Comment: December 14, 2009
The holidays are a great time of the year to be thankful for what the current year has allowed us to achieve and to be hopeful about what the coming year will be. 2009 was a pivotal year for the market to say the least. My intention here is to provide some context on the path of earnings, their outlook for 2010 and the implications for equity market. I will be the first to admit there are many issues to consider as one looks forward to the coming year. I only wish to isolate what the earnings outlook may mean for the level of the S&P 500 as a proxy for the overall equity market.
First, have a look at the history of the S&P 500 “operating earnings” since 1988 to present. I use operating earnings instead of “reported earnings” in an effort to knock off some of the blips created by write offs and other non-cash impacts. The white circles are the earnings now estimated for Q4 2009 going out to Q4 2010.
Following the collapse in Q3 and Q4 2008 and in Q1 of 2009, earnings have made a remarkable recovery. Expectations are that quarterly earnings will be back on the long term trend by Q2 of next year. To say that the year over year comparisons will be forgiving is an understatement.
It is intuitively obvious that if earnings growth recovers, so do equity prices. That is exactly what has happened this year. As earnings growth has turned sequentially positive and is headed toward dramatically positive year over year growth, the S&P 500 has appreciated 22%. My call is we are still in the early months of an earnings and equity value recovery similar to 2003-2004.
There are analysts who believe that the 2009 market recovery has been too strong and too fast. They may be right but a look at the earnings spread and its impact on fair value suggests otherwise. The present earnings yield (the reciprocal of the PE Ratio) for the S&P 500 is 154 basis points above the 10 year U.S. Treasury rate. One can argue the Treasury rate is too low. That is not the point here. I like to say that we need to “live in the Land of IS” – not the maybe. The spread of earnings yield over the 10 year Treasury is something we can measure discretely, is market based and has a good record of contributing to directionally correct models. Here is a chart of the spread since 1988.
When the spread is positive, equities tend to be undervalued. When the spread is negative – equities tend to be overvalued. Market history since 1988 tells us that a positive earnings yield spread, such as the 1.54% today, is consistent with a rising market 83% of the time in the following quarter and 90% of the time over the next 12 months.
Some of you may recognize the following chart that illustrates the periods of over and undervaluation of the S&P 500 since 1970. The market today is 30% UNDERVALUED by this measure. In this case I use the 10 year Treasury yield as “cap rate” to infer a P/E ratio for the S&P 500.
The historical context of the above chart is framed by the data in the following table. The S&P 500 has been 30% or more undervalued in 15 quarters since 1971. The market has been up 12 months later in 86% of the cases by an average of 15.6%. There have only been two instances – March 2009 and September 2009 – when the market was lower 12 months after being as much or more undervalued as today. Clearly the performance of the market in 2009 may be considered an outlier. No doubt the sample size is limited.
As you consider the likelihood of the market extending its recent run please consider the rarity of the current velocity of earnings recovery we have experienced and expect to experience in 2010. As many of you have read in my prior notes we have seen record levels of positive earnings surprises this year. The earnings for the S&P 500 are currently expected to rise nearly 46% in the current quarter over Q4 2008. Earnings are expected to have peak year over year growth in Q3 of 2010 of approximately 80%. We have only seen this type of growth twice in the last 90 years. We saw 74% growth in Q3 1947 and 74% growth in Q1 1935. The S&P 500 went on to rise 76% twelve months after the 1935 event but only rose 2.5% in the twelve months after the 1947 event. The highest year over year growth we have seen in more modern times was 33.5% trailing 12 month earnings growth over the prior year in Q4 1988. The market rose 27% in the following twelve months.
Many of you may be very concerned about potential inflation, runaway fiscal deficits, a “weak” US$, Obamacare, Iranian nuclear threat, the ongoing war on terror, the impending increase in tax rates in 2011 . . . I could go on. These are all legitimate concerns . . . but they don’t stop the economy here or globally. Being concerned is advisable. Frozen in the headlights is not. The S&P 500 is up 66% from its low point in March. The Aberdeen portfolio is up 94.5% on an equal weighted basis from its low point in November 2008. The market is entering a period of unprecedented annual growth from a position of relative undervaluation. 2010 should see an extension of the impressive rally experienced in 2009 albeit with a risk of normal corrective action along the way.
The downside in the near term is limited. The upside is we may see a “melt up” of near historic proportions if the bond buyers and cash holders finally capitulate and move into equities over the next 90 to 120 days.