Tuesday, February 28, 2012

S&P 1800?

"Could stocks be cheap?"

Dan McCrum had an interesting column in last Saturday's Financial Times.

Unlike the usual discussion of how financial Armageddon is right around the corner (please see yesterday's Random Glenings post), McCrum walks through the math of how the S&P could actually be undervalued at current levels.

I'll discuss his logic more fully below, but here's how he concludes his column:

So, come 2014, the companies of the S&P {500} might produce $125 or $130 of net profits. Perhaps they won't start to buy each other, pushing up valuations, and maybe savers will continue to prefer the safety of bonds even as inflation eats away at their nest egg.  But at 14 times earnings that would still translate into a market above 1,800.

Perhaps 2012 will be the year of missed opportunity?


What, I hear you say, how can this be?  Aren't you worried about the euro; Iran; budget deficits; and a lethargic housing market?  

How can you possibly say that stocks could rise more than +30% from current levels?

Well, the logic is fairly straightforward.

Yes, we are probably in a slow-growth world for a while.

McCrum assumes that the emerging markets will grow 4% to 6% in the next few years, which is actually below recent rates of growth.  Developed markets, meanwhile, will probably only grow at a +2% pace, also below historic trends.

All told, the overall average rate of growth for the global economies could run at +3% per annum.  Nothing too aggressive in this assumption.

Now, if the top line of the companies in the S&P mirror the global growth rates, revenues should grow at +3% per year for the next few years.

If this is the case, and company margins are maintained at around current levels (or slightly lower), earnings should grow at +6% a year.

With corporate cash levels at record high levels - about $2 trillion, at last count - the trend towards share buybacks should continue, despite the fact that many investors would prefer higher dividend payouts.

If corporations continue to buy shares back at current rates, earnings per share could easily grow at +8% a year for the next few years.

OK:  3% top line growth, 8% earnings per share.  What does this mean in terms of the market?

Consensus earnings estimates for the S&P 500 this year indicate that analysts expect the composite to earn $103 in 2012.  This, by the way, is no change from 2011, and I think this could be too pessimistic.


Now, assuming that the S&P earnings grow at +8% per year in 2013 and 2014. This translates into 2014 earnings of more than $120. 

Putting a 14x earnings multiple on $120 yields a S&P level of nearly 1700. 

If 2012 earnings return to the last five years trend growth rate of +3% per year, this gets 2014 earnings closer to $125, which gets you to McCrum's level of 1800 on the S&P (14 x $125 = $1750).

Now, the bears will argue that assuming a 14x earnings multiple is too high, despite the fact that:
  • the median S&P multiple for the last 20 years has been 18x;
  • the lowest S&P multiple (in 2009) was 11x;
  • the Fed has already announced that it will keep interest rates historically low through the end of 2014.
In other words, I think that 14x is fairly conservative in today's low interest rate environment.

Of course there's lots that can go wrong.  However, I would challenge the uber-bears on the world and the markets to walk me through how exactly they believe stocks will continue to disappoint.

An S&P level of 1750 in 2014 would only be +13% higher than the S&P in 2007, when earnings were $90 for the index.

The S&P was also around 1550 in 2000, when earnings were around $50, but the multiple at that time was still in the throes of the "bubble era".

Or, put it another way, there's probably more opportunity than risk in today's markets, despite the recent run-up.