Tuesday, September 29, 2009


Taking the Bait…S&P 500

We still think that equities will trade in a broad range for an extended period. The current rally is typical of what follows major bear markets and is not, in our view, the start of a new multi-year bull market. However, we now think it can run on for longer than we previously
expected, so we are upgrading our year-end S&P 500 target.

We previously expected the S&P to end the year at 900, with a near term stretch target of 1100 (14x two-year forward earnings). We think equities will now trade above this, in large part because earnings will be higher than we previously anticipated. We now expect 2009 and 2010 earnings to be $55 and $70, respectively. This implies a year-end 2009 fair value of 1050 ($70 EPS on 15x). A higher multiple would justify a higher target, but we don’t see a compelling reason why equities should trade significantly richer in the current environment, despite low official interest rates.

With risk assets in a sweet spot (growth momentum improving, rates are on hold, and liquidity measures plentiful) for at least the next 2 quarters, we think the market will trade away from our fundamental valuation before growth and earnings concerns resurface and potentially disappoint expectations built in equities. At 1200, however, we would turn cautious unless there has been a material change in the fundamentals.

What worries us? 1) There is now a strong consensus view that equities will trade higher into year-end, yet few clients hold this view with high conviction; 2) the simultaneous rally in both bonds and equities highlights a strong divergence in views on growth, which will at some stage need aligning; 3) earnings/margin expectations are following the normal pattern of cyclical
cost underestimation; and 4) all asset views are highly aligned to a depreciating US dollar.

To see full report: EQUITY STRATEGY