Is the equity market overpriced and vulnerable after its sharp rally off the March 2009 lows, as suggested by the bears? While the economy has many problems to overcome, equity valuations are actually quite reasonable, even after the market's surge off the bottom. As always, the economy's performance is critical to the outcome.

The surge in market prices off the bottom is hardly the right benchmark to judge whether equity prices are reasonable. The consensus estimates for S&P 500 2010 earnings is for $76.39. With the S&P closing at 1144.98 on Friday, the market's P/E is 14.99, near the extreme lows of the past 20 years. Typically, the market anticipates recovery before it gets rolling and the price earnings multiple tends to be quite high at that point, just as stocks typically trade at a low P/E during booms, when earnings may not be sustainable. The very fact that the P/E multiple is so abnormally low for this stage of the cycle implies that investors do not believe the earnings estimates. Cash levels have retreated from their peak relative to the market, but only because the market has rallied, not because much cash has moved into equities. Many doubt the market's prospects.

In fact, investors have very little confidence in any aspect of the market or the economy. Investor capital flows in 2009 were overwhelmingly into bond funds, while stocks funds attracted virtually nothing at all. Even now, despite a 60% rally off the bottom, bears continue to forecast that the market is overvalued and likely to retest the lows! One well known bear suggests she is more bearish than she has ever been! Another forecasts the unemployment rate to exceed 13%. In this context, the market should continue to rally. There's too much cash on the sidelines and too many people have missed it and will eventually be forced back in.

The key, as always, is the economy's performance. Last year was so traumatic that investors and analysts are inclined to be very cautious. Expectations for the economy remain modest. The consensus only expects about 3% growth this year, far below the normal pace for the first year of a recovery. However, profit margins rose in the first three quarters of 2009, even in the first quarter when GDP fell by 6-1/2%. Earnings are likely to surge in 2010 if growth comes in better than expected. It is entirely possible the market will continue climbing its wall of worry, particularly if the economy performs even a bit better than commonly expected. In fact, we continue to expect both the economy and the market to exceed investor's meager expectations.

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