1/20/2010
By Carlos Guillen, Semiconductor Analyst

In taking a look at the S&P 500 index trajectory during 2009, I find it quite remarkable how much this index has increased from its March low of $677 to the $1115 reached by the end of 2009, representing a growth rate of 64.7%. However, the momentum has not stop there, and the index has slowly been creeping up to about $1138, representing a growth rate of about 2% in less than three weeks of trading. At its current level, the S&P 500 index is just about to surpass my projected target of $1144, which I expected to be reached by mid August 2010. At this juncture, it is inevitable to ask, where do we go from here? Will the equity market's momentum continue?

The economy is certainly recovering as a result of quick actions taken by the Fed and the Government to steer it away from heading towards another Great Depression. It is fair to say that the macroeconomic backdrop has actually turned out to be much better than most expected. In fact, after four quarters of negative GDP growth, the most recent third quarter GDP growth revision clocked in at an annual rate of 2.2%, and the fourth quarter GDP rate is currently projected to land at 4.2% (to be released on Friday, January 29, 2010). Given that the macroeconomic backdrop has turned out to be much better than most expected, in the sense that we have not only avoided "Armageddon" but also returned to GPD growth much sooner than expected, earnings estimates for the S&P 500 are now expected to be quite high. According to the S&P, earnings per share are expected to be $58.71 in 2010 and $69.66 in 2011, up from an estimated $48.17 in 2009.

I must point out that these estimates are, what is called, "top-down operating earnings." S&P shows "operating earnings" as top-down and "as reported earnings" as bottom-up. Bottom-up operating earnings exclude write-offs and one time abnormalities, and it reflects Wall Street analysts' estimates (including analysts at the S&P) for each stock in the S&P 500. Top-down as reported earnings (basically GAAP earnings) reflect the views of economist, for the most part, which look at macroeconomic fundamentals in conjunction with net income and profit margins of the broader economy. Nonetheless, while I believe that earnings growth rates of 21.9% and 18.7% for 2010 and 2011, respectively, are somewhat excessive, they are indicating that the market expects to see strong growth in earnings for the next couple of years.

Well, let's look at the fundamentals. Let's see what expected dividends, growth, and risk have to say about the intrinsic value of the S&P 500. In order to arrive at a fair value for the S&P 500 index, I used the same methodology that was described in my article titled "Is the Market Fairly Valuing the S&P 500?" Given that S&P 500 earnings growth projections are rather high, I chose to use the 20-year average earnings growth rate of 15.9% for 2010 and ramped this down by two percentage points till 2014. In order to determine the initial "Dividend & Buybacks" of $53.94 per share, I used the ten-year average dividend yield of 4.74% (including buybacks) and multiplied it by the S&P 500 index closing price of about $1138 as of January 20, 2010. To account for increasing risk to future cash flows, I increased the cost of equity significantly in accordance to the current appropriate bond rates from the Treasury website. Our cash flow, risk, and growth assumptions are tabulated below, and they lead to an intrinsic value of approximately $1309.

My estimate represents a premium of 15.0% over the $1138 closing price on January 20, 2010. Therefore, according to my analysis, the S&P 500 is still intrinsically undervalued, and its momentum should continue. In terms of when this price level will be achieved, I believe that a year is more than reasonable.

Carlos Guillen
Wall Street Strategies