With the S&P 500 having advanced 20.4% year to date as of 10/16/2009, and the MSCI EAFE index up 28.2% over the same period, it is legitimate and prudent to question the sustainability of this advance. The equity markets have been fueled by liquidity, a steady diet of improving news flow about the economy, and bona fide improvements in corporate performance. Nevertheless, after such a torrid advance from the lows of March, there is scope for a pullback, suggesting that investors should practice prudent portfolio rebalancing in order to keep portfolio risk aligned with their tolerance and capacity for volatility.
A few notable observations have crossed my desk in the last few days:
A few notable observations have crossed my desk in the last few days:
S&P 500 Fair Value
According to Bank of America Weekly Strategy Insights dated 10/19/2009, Bank of America strategists believe the fair PE multiple for the S&P 500 is 16.5x (this is based on 6% real cost of equity capital). According to this multiple, at 1097.25 the market is implying $66.00 in normalized earnings, in line with the current quarter’s annualized EPS. However, Bank of America believes that the current quarter’s earnings are still cyclically depressed, and they expect that the S&P 500 will grind higher as investors raise their expectations for the S&P’s normalized earnings power.
Visitors to the Standard & Poor’s website will see that S&P’s estimate for 2010 S&P 500 operating earnings is $73.55 (as of 10/19/2009). Using the Bank of America Fair PE Multiple of 16.5x on this earnings estimate would imply a fair valuation of 1214 at some point over the next six to nine months.
I have often used the “Rule of 20” to calculate a fair value multiple for the S&P 500. The crude assumption behind this rule is that 20 minus the rate of inflation represents a fair value multiple for the S&P 500. Using the yield of the 10 Year Treasury minus the real yield on the 10 year Treasury Inflation Protected Securities (TIPS) one can derive today's market expectation for inflation of 2.05%. (10 year treasury yield 3.37% - 10 year TIPS yield 1.32%). This yields a fair value multiple of 17.95x using the Rule of 20. While this is somewhat higher than the Bank of America Fair PE it is within the same ballpark.
Regardless of which method one uses to calculate a fair value multiple, the market appears to offer upside from here if earnings do not disappoint versus current expectations.
The Rush to Buy Bonds
In this weekend’s Barron’s, Michael Santoli pointed out that there have been $11 dollars in net inflows to bond mutual funds for every net dollar into equity funds over the past three months.
Bonds are an important part of most investor portfolios. Treasury bonds because they offer tremendous liquidity and are backed by the full faith and credit of the U.S. Government, and other types of bonds (Investment Grade Corporate, Municipal, Mortgage, Senior Secured Loans) because they can offer income and portfolio diversification benefits alongside cash and stocks. Amidst the recent market turmoil, many investors have reintroduced themselves to this asset class in search of the previously mentioned benefits. We have supported this notion. However, we cannot overlook the current love affair that investors of all stripes are showing toward this asset class and not point out that this supports the overall attractiveness of equities.
Equities remain an asset class that is vitally important for many investors who possess the goal of growing the value of their principal and preserving its purchasing power versus inflation. With a nod to the above data point from Barron’s, it is fair to say that investors have not been rushing to buy stocks despite the significant advances year to date, and particularly from the lows. This, combined with valuations that certainly appear reasonable, continues to support the case for owning equities, as well as bonds, and not being afraid to rebalance in the direction of equities for investors who possess the capacity for the potential volatility.
According to Bank of America Weekly Strategy Insights dated 10/19/2009, Bank of America strategists believe the fair PE multiple for the S&P 500 is 16.5x (this is based on 6% real cost of equity capital). According to this multiple, at 1097.25 the market is implying $66.00 in normalized earnings, in line with the current quarter’s annualized EPS. However, Bank of America believes that the current quarter’s earnings are still cyclically depressed, and they expect that the S&P 500 will grind higher as investors raise their expectations for the S&P’s normalized earnings power.
Visitors to the Standard & Poor’s website will see that S&P’s estimate for 2010 S&P 500 operating earnings is $73.55 (as of 10/19/2009). Using the Bank of America Fair PE Multiple of 16.5x on this earnings estimate would imply a fair valuation of 1214 at some point over the next six to nine months.
I have often used the “Rule of 20” to calculate a fair value multiple for the S&P 500. The crude assumption behind this rule is that 20 minus the rate of inflation represents a fair value multiple for the S&P 500. Using the yield of the 10 Year Treasury minus the real yield on the 10 year Treasury Inflation Protected Securities (TIPS) one can derive today's market expectation for inflation of 2.05%. (10 year treasury yield 3.37% - 10 year TIPS yield 1.32%). This yields a fair value multiple of 17.95x using the Rule of 20. While this is somewhat higher than the Bank of America Fair PE it is within the same ballpark.
Regardless of which method one uses to calculate a fair value multiple, the market appears to offer upside from here if earnings do not disappoint versus current expectations.
The Rush to Buy Bonds
In this weekend’s Barron’s, Michael Santoli pointed out that there have been $11 dollars in net inflows to bond mutual funds for every net dollar into equity funds over the past three months.
Bonds are an important part of most investor portfolios. Treasury bonds because they offer tremendous liquidity and are backed by the full faith and credit of the U.S. Government, and other types of bonds (Investment Grade Corporate, Municipal, Mortgage, Senior Secured Loans) because they can offer income and portfolio diversification benefits alongside cash and stocks. Amidst the recent market turmoil, many investors have reintroduced themselves to this asset class in search of the previously mentioned benefits. We have supported this notion. However, we cannot overlook the current love affair that investors of all stripes are showing toward this asset class and not point out that this supports the overall attractiveness of equities.
Equities remain an asset class that is vitally important for many investors who possess the goal of growing the value of their principal and preserving its purchasing power versus inflation. With a nod to the above data point from Barron’s, it is fair to say that investors have not been rushing to buy stocks despite the significant advances year to date, and particularly from the lows. This, combined with valuations that certainly appear reasonable, continues to support the case for owning equities, as well as bonds, and not being afraid to rebalance in the direction of equities for investors who possess the capacity for the potential volatility.
Important Legal Information:
Past performance is no guarantee of future results. Investing involves the risk of loss. This material should not be used as the basis for investment decisions on its own. Prior to investing, an investor should assess the specific risks of given instruments and determine (with his or her professional advisors) if the investment is suitable for his or her circumstances.
Taylor Thomas
10/20/2009
Posts
