Stock Market Valuations Could Suggest Further Gains – Published in Noozhawk on Monday, December 29, 2013

The Standard & Poor’s 500 index began 2013 at 1,426 and ended last week at 1,841, which represents a 415-point or 29 percent gain for the year so far. This is the best performance for the S&P 500 in a decade. Looking ahead, what can we expect for stocks? One way to gauge the probability of a strong follow-up year for stocks is to look at current valuations.

World gross-domestic product for 2013 was $73.2 trillion, compared to $56 trillion in 2007, a $17.2 trillion or 30.7 percent increase. US GDP was $16.5 trillion for 2013, versus $14.5 trillion in 2007. This change represents growth of approximately $2.0 trillion over the six-year period, or a 13.8 percent change. (These are current dollar values, so the effect of inflation has been included. Sources are the CIA World Fact Book and the International Monetary Fund.)

The S&P 500 peaked at 1,565 in 2007. The current level for the index of 1,841 represents a 276-point increase, or a 17.6 percent gain. A quick comparison to the increase in GDP over the 2007-through-2013 time period reveals that stocks are at a significantly higher valuation today, compared to the level for stocks at the market peak in 2007, prior to the financial crisis that began late in 2008. Based on GDP, an equivalent market level for the S&P 500 would be 1,781. This means that stocks, based on U.S. GDP, are at a 3.4 percent premium to their peak GDP-based valuation of 2007.

Using another method for valuing the stock market, we can analyze operating earnings (bottom-up) for the S&P 500. For 2013, operating earnings for the S&P 500, including Standard & Poor’s latest estimate for Q4, are expected to be $107.25, which gives us a P/E price-to-earnings) ratio of 17X. For 2007, they were $82.54, giving us a P/E ratio of 19X. Earnings growth over the six years has therefore been $24.71, or an increase of 29.94 percent.

Based on this valuation metric, we could say that compared to the peak level for the S&P 500 in 2007, stocks are still undervalued. Using the growth in earnings over the six-year period, we could say that, to get back to the same valuation at the peak of 2007, the S&P 500 would need to move up to 2,034, or by an additional 193 points or 10.5 percent from the current level.

Stocks often trade on expectations for future earnings. We can look to 2014 estimated earnings for the S&P 500, which are expected to be $121.51 (which gives us a forward P/E of 15X), to value stocks. Based on this estimate, and comparing the index to the peak of 2007, the S&P 500 would need to increase to 2,309 to have the same valuation (to have a 19X P/E ratio). A move to this level would represent a gain of 468 points, or 25.4 percent.

As I noted in last week’s column, it is not uncommon for stocks to generate double-digit returns in years following years with strong performance. However, as with investments of all types, we must consider the possibility of further substantial gains in the context of the investing environment we will face in 2014. With theFederal Reserve removing stimulus from the economy (tapering off its bond buying, starting in January with a $10 billion reduction), and interest rates already pushing above 3 percent for the 10-year treasury, economic growth will face significant headwinds. Just because analysts at Standard & Poor’s are predicting solid earnings growth for 2014 does not guarantee that this will occur. Analysts are frequently wrong, and are, more often than not, overly optimistic, especially in times of strong stock market performance.

The Fed will have to thread the needle carefully, to avoid removing stimulus too quickly, resulting in stunting economic growth and/or spiking interest rates, much like playing the classic game Operation, in which the player tries to remove the patient’s bones without touching anything else. If you remember this game, you know that if the player touches anything, a buzzer sounds and red lights flash, and the player loses. Hopefully, the Fed will not suffer this fate.

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