2-16-2010

Updating The Envelope

Last August, I forecast the level the S&P would trade at in the summer of 2011.  I used the “back of the envelope method”.  This entailed multiplying the earnings estimate for 2012 by the then likely PE ratio of the market.  It resulted in a forecast of an additional 50% upside in the market, with the S&P forecast to be trading around 1540.  Shortly thereafter, I appeared on CNBC with Maria Bartiromo and went through the math.  She loved it because I was sticking my neck out.  The other guest on the program thought I was nuts.  It’s probably worth updating the economy and market’s progress toward that goal. 

Last August 24^th, the S&P 500 was 1025.  Today it’s 1075.  We’ve made progress, but hardly at a rate that would get us to 1540 in 18 months.  Let’s examine the fundamental assumptions we made and mark ourselves to market on the progress toward them.  There are two parts to look at:  earnings and multiples.  In August, we looked at earnings this way:

“When the market bottomed in March, many people said the S&P 500 would earn less than $50 per share this year. It is highly likely that the S&P will actually earn something between $55 and $60 per share this year.  It’s likely that next year, in a recovery year, the S&P will earn around $80. In 2011, companies can earn between $88 and $92 per share, and it is entirely possible that the S&P 500 can earn $100-105 per share in 2012. Two years from now, in the Summer of 2011, market participants will be projecting those 2012 earnings.”[i]

The S&P 500 earnings for 2009 are likely to have come in closer to $70!!!!   Back in August, it seemed kind of nutty to be using $80 for this year’s estimate.  Now, however there are a lot of estimates in that range.  We stuck our necks out even further estimating $88-92 for 2011, but I’ve found experts that I respect now estimating $95 for 2011.  The $100-105 range I prognosticated for 2012 doesn’t even seem like a stretch anymore.  Obviously, the better than expected run of four quarters in a row of positive earnings surprises made these numbers seem possible.  As we’ve harped on in the past, analysts underestimate in recoveries just the way they overestimated at the beginning of the recession. 

Even with these earnings in reach, the vast majority of market watchers are not particularly bullish on the market outlook for the next two years.  This means that they either are expecting the earnings stream to reverse course or they are very bearish on multiples. 

Multiples are made of assumptions concerning interest rates and growth rates.  The higher the expected growth rates of earnings and therefore dividends, and the lower interest rates are, ceteris paribus, the higher the multiple will be.  When you are in the middle of a recovery, it’s very hard to nail down what the multiple is, because the earnings expectations are changing so rapidly that you can’t tell if the market is being valued on trailing or expected earnings.   However, we are clearly going through a period where the expected rate of growth of earnings is going up; that’s the definition of positive earnings surprise.  We couldn’t be at a lower level of interest rates, so the real question is how fast and how far interest rates go up. 

The good news is that the Catch22 that we are now engaged in leads me to believe that it almost doesn’t matter.  If rates go up faster than expected, we certainly didn’t have a double dip and quick earnings growth will continue.  From zero money rates and a 4% bond rate, we have a long way that we can go before the discount rate on dividends will be high enough to disturb my assumption of a 15 multiple on estimates for 2012.  

My conclusions are twofold. 

1. The first is that much to my delight, back of the envelope calculations still work.
2. The second is that looking for a market level 50% higher in eighteen months is still totally possible.

The wall of worry is a funny thing.  It always makes you doubt your assumptions.  The higher the recovery market goes--the more reasons why it can’t go higher pop-up.  It never feels good to buy corrections, but it’s the best way to repair your net worth.

Fred S. Fraenkel
Vice Chairman and
Chairman of Investment Policy
Beacon Trust Company

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