Thoughts on the 2010 Stock Market

So, we got through earnings season OK.

Next Major Signpost:

The next major issue confronting investors will likely be the impact of the government’s fiscal and monetary credit expansion on the economy.

Will such a credit expansion lead to an increase or acceleration of inflation?

What will the impact of inflation have on equity valuations?

Inflation’s Impact on Stock Market Valuation:

Below is a chart of the “earnings yield” (P/E ratio inverted) of the S&P 500 versus the CPI –U (All Urban Consumers) index. The S&P 500 earnings yield is calculated by dividing the year-end EPS of the S&P 500 by its year-end index value. Example Below.

The graph above shows a positive relationship between the YOY change in the CPI and the S&P 500’s earnings yield at year-end.

This means that as inflation increases so does the earnings yields of the S&P 500. Since the P/E is the reciprocal of the earnings yield, an increase in inflation would lower the P/E and create a lower relative valuation for the S&P 500.

This would make sense:

As inflation increases investors would require a higher earnings yield to generate a “real return” (nominal return minus inflation).

In Search of a Real Return:

The average and median real earnings yield for the S&P 500 since 1942 has been 3.4%.

Based on a forecasted inflation rate for 2010 of 2.0%, the nominal earnings yield would be 5.4%. The P/E (reciprocal) would be 18.5.

Whether by the “luck of the draw” or the model’s merit, the current S&P’s trailing P/E is approximately 18.5. Based upon an estimated 33% YOY increase in S&P 500’s 2010 EPS and the current P/E, the S&P Index would be valued at 1400 year-end 2010.

The index would be up approximately 27 % from its current level based on these estimates.

Lurking Bears?

The “Bears” will be looking for the first sign of credit tightening.

When it does appear, we’re likely to have the Dow down 300 points on that day.

So get your “shorts” ready.

Then after the market stabilizes, be prepared to aggressively buy for an interim holding period as the S&P 500 will rally back.

When Predicting, Predict Often:

Central to this hopeful stock market outlook is the sanctity of the S&P 500 earnings projections. Analysts are notoriously late in calling earnings estimates and buy/sell recommendations. Analysts were collectively late at the peak and they’ll be underestimating earnings at the bottom. So, there’s a little positive wiggle room on projected earnings.

However, Don’t Get Too Excited: The events that move the stock market aren’t generally events you can predict—and this may be particularly true for 2010.

Domestic and geopolitical events that result in economic disruption, i.e., war, terrorism, bad policies, even atmospheric or geological events, such as hurricanes, famines and earthquakes, etc., are the stuff of major market disruptions.

No one predicted “9/11”, and judging by the post-analyses of the event, few even had a clue.

The probability of a random “out of the blue” event impacting the stock market is high--particularly, given the shifting sands and loose fabric of global leadership and the US’s vulnerability as its assets are spread thin.

As Voltaire, wrote to Fredrick the Great in 1767, " Doubt is not a pleasant condition, but certainty is an absurd one."

While being constructive regarding the 2010 stock market outlook, you still may need to sit next to the exit

Example: a stock has a price of $21 and year-end EPS is $3.

The earnings yield would be: 14.3% (3/21 = 14.3%). The P/E would be 7 times (21/3).

If you divide 1 by the P/E (7) you would arrive at an earning yield of 14.3 %.