March 8, 2010Many investors are now dismayed they missed out on the dramatic market rebound off the March 9, 2009 low, whose one-year anniversary is tomorrow. In fact, many investors were anxiously eyeing the exit, if they hadn't already bailed out of stocks a year ago. That was a scary time and it required extraordinary policy initiatives to address the economy's many problems. What's past is past. Does the rally suggest that stocks are now expensive? It is our judgment that equity valuations are quite reasonable, despite the sharp rise in stock prices over the past twelve months. As long as the economic recovery continues, or even more so if the recovery proceeds slowly, stocks should perform very well over the next year, and possibly considerably longer.
The consensus estimates about $75 in earnings for the S&P 500 in 2010, a cautious figure that is based on a very weak recovery in GDP of around 2.5%. Both figures are too conservative. In fact, profit estimates were significantly too low throughout 2009 right through the fourth quarter. We expect GDP growth between 3.5% and 4%, which implies profits north of $80 for the S&P, possibly as high as $85. Profits in 2011 should approach $100. Using a price earnings multiple of 16 implies an S&P 500 of 1,360, almost 20% above Friday's close. Using a price earnings multiple of 15 on 2011 earnings implies another gain of more than 10% next year. Neither of these earnings multiples is aggressive, particularly if interest rates remain fairly low.
A slow or moderate paced recovery implies that inflation pressures should remain muted for longer, which implies interest rates remain low and justifies even higher price earnings multiples. Some forecasts that combine a slow pace of recovery with higher inflation or a poorly performing stock market are simply internally inconsistent. Rather, if the pace of recovery is quite moderate, unemployment will come down only slowly, which implies that inflation will also remain muted. In that kind of environment, the Fed will be very reluctant to raise interest rates and the equilibrium price earnings multiple should be quite high.
The primary risk to the stock market, aside from the possibility of a shock of some sort, is that the recovery will be too rapid, more so than currently expected. In this scenario, the Fed will quickly come under pressure to raise interest rates significantly to keep inflation at bay. This possibility does not appear to be overly likely right now, but it should not be dismissed, even though most forecasts suggest a tepid recovery, at best. Instead, there appears to be more fear of a double dip recession. Once an expansion gains some traction, it tends to become reinforcing and builds on itself. So, it is our judgment that this is a vastly overblown concern, particularly since there never has been a double dip recession.
In truth, it is somewhat premature to have a high level of conviction in any forecast of the pace of recovery when the labor market is still losing jobs, even if those job losses are now minor. The outlook will not become clear until we can see how much self-reinforcing job growth is underway once the expansion has gathered momentum. Such judgments may await the summer.
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Advisors Capital Management, LLC (ACM) is a provider of privately managed portfolios and financial planning services for industry professionals and direct clients. Although the information included in this report has been obtained from sources ACM believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. ACM is a registered investment advisory firm. For program fees and descriptions please request a copy of the firm’s ADV part II Schedule F. Web Address: www.advisorscenter.com 777 Terrace Ave, Hasbrouck Heights, NJ 07604 Phone: 201-426-0081
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