DCM's Investment Policy Committee continued to examine the data in our meeting this week to try to determine whether we are experiencing a normal stock market correction, or a market that is signalling that something has gone wrong with the consensus view of the economy and corporate earnings.
(Note: Our discussion, summarized below, ended in a consensus view by the Committee that if the upcoming corporate earnings season confirms the current forecast of $82 for annual 2010 S&P 500 earnings, then the current market pullback will reverse itself, possibly dramatically, sometime over the next few months.)
The Committee reviewed economic data and outlooks around the world, corporate earnings guidance from S&P 500 companies, and many other data points.
This week, we looked at a multiple regression analysis that assessed the correlation of core CPI rates with earnings yield of the S&P 500 Index. Earnings Yield is just the flip of P/E. That is, it is E/P instead of P/E. We used this inverted P/E in order to better see the "fit" when charted on a line graph. (See below) Click the chart to enlarge.
That analysis shows a tight correlation between core CPI and E/P, with an R2 of .71. The formula derived from the multiple regression indicates that the trailing P/E of the market with core CPI standing at .9% should be about 20X, not the current 14.8X.
If the market “should be” at a 20.2 P/E based on the historical statistical best fit between earnings yield and core CPI, then it is over 30% undervalued, excluding any contribution of earnings over the remainder of the year.
The economic recovery is definitely slowing. Our research, however, brings us to the belief that the economy is still expanding. It is not contracting. Further, during last year’s fourth quarter we, and many other forecasters, predicted that GDP growth in 2010 would slow down in the second half of the year. Everything we see, other than the stock market, is consistent with that forecast. The sharp sell off in stocks over the past three months is reflecting a more pessimistic view of the economy than we can envision at this time.
For the current P/E, and thus current S&P 500 stock price to be correct, earnings for the rest of this year would have to drop by 50% - 75%. A fall in earnings by that magnitude seems highly unlikely to us. Indeed, we believe earnings will continue to surprise to the upside.
We believe that the market sell off in recent weeks is the result of many factors, including: worries about the Administration's attitude toward business, low volume, bearish bets by short-term traders, emotion having greater influence on stock trades than facts, and some vague feelings of skepticism toward 2010 profits by some invesors.
As the earnings reports actually start coming out next week, we believe the market can regain its footing and take back some of the sell off that has so unnerved so many investors.
Having said this, the Committee will be watching and listening very closely to these announcements for any sign of significant earnings outlook deterioration.
Absent a pessimistic turn in earnings, it is hard for us to accept that overall market prices won’t begin turning up – possibly significantly up - before year end.
Randy Alsman, Editor