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S&P Valuation Exercise
These days, the market action is often described as the "most hated rally ever." The Dow and S&P 500 recently broke into multi-year highs but at the same time Europe is in shambles, China is slowing and the US is grinding to a halt. Although investors are keen to take part in the rally, you rarely hear anyone singing the market's praises, myself included. Often times the prevailing explanation is that Federal Reserve funny money (and the prior anticipation of it) is goosing stocks.
Well, I'm feeling pretty chipper today so I'm going to try to play Devil's Advocate against all the naysayers for once. The best argument that I can attempt for market bulls is in the valuation of the market itself. Despite a strong rally over the past year, the market is still coming off of historically very low valuation levels as measured by price to operating earnings.
In 3Q of last year the S&P 500 was trading with an operating P/E ratio of 11.95, which was the lowest it had been since 1989. Yet, since 1989 the average operating P/E ratio of the S&P has been all the way up at 18.97. Therefore you could say the market had been trading well below "normal" valuation last year, and with a current price of just over 14 times expected 2012 operating earnings you could say that valuation remains low.
Yet, even trading at a historically very low valuation, you could still argue that it's justified. That's because since a year ago, 2012 operating EPS estimates have come down from approximately $110 to approximately $103, and they continue to slide. Therefore, it would make sense that investors would value the market with a lower growth premium (the P/E), considering expectations are decelerating.
By that token, I suppose you could say that the current operating P/E between 14 and 15 is fair, especially considering the historical average of 18.97 includes a couple of big bubbles (tech and housing) that lifted the P/E to nearly $30. Nevertheless, the current estimate for 4Q would still represent the highest quarterly operating earnings in history ($26.94), believe it or not.
Alright, so I've made a valiant effort to appease the bulls. Perhaps by this method you could say that the market is fairly valued where it is. But I think investors would still be hard pressed to prove that the market should be valued much higher. Over time, one could say that it would be fair for the S&P to return to that 18.97 average P/E but for that to happen earnings expectations would need to be on the rise, not flat-lining as they are now.
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