Thursday, October 29, 2009


Investor focus has shifted from earnings to valuation. We are now most often asked at what P/E should the market trade. We offer four approaches: (1) history of multiple expansions from bear market lows suggests 14.1x; (2) our top-down P/E model suggests 13.7x; (3) our DDM-derived 2009 price-target of 1060 implies 13.1x; and (4) the Fed Model implies 16.4x.

P/E multiples will likely remain below average in 2010
Our top-down regression and DDM models cannot precisely pinpoint a correct P/E multiple. However, the current weak macroeconomic backdrop as well as the historical trading pattern of bear market recoveries suggest P/E multiples will stay below average in 2010. Our forecast that multiples will remain below average represents an out-of-consensus view based on recent conversations with a wide range of portfolio managers. Many investors expect S&P 500 will reach 1200 by year-end. However, we believe it will take a higher E – not higher P/E – for the market to sustain levels above our current 1060 target.

The debate has shifted from EPS to valuation. During the past 18 months, we have focused our research primarily on the earnings power of the market and the trajectory of S&P 500 EPS. This emphasis was appropriate given forward bottom-up consensus EPS estimates for the S&P 500 plunged by 37% from $98 in September 2008 to $62 in May 2009. During the past five months, however, EPS estimates have edged up slightly, currently hovering around $68. Given the recent stability of earnings estimates, investor focus has shifted from earnings to valuation.

The Multiple Mystery: At what P/E should the market trade?

(1) History suggests 14.1x, or 34% expansion from the trough
Historical analysis reveals a consistent pattern of bear market recoveries: first multiple expansion, then earnings growth. The market multiple tends to expand by 34% during the first 10 months following a bear market trough but then remains flat during the subsequent 12 month period. Since the March low, multiples have risen by 30%, on track with historical precedent, to 13.6x currently. A further 4% rise would lead to a 14.1x P/E.

(2) Top-Down P/E Regression suggests 13.7x
Macro model of inflation and the output gap suggest multiples will remain near current levels into 2010. Both variables appear negatively correlated with P/E (output gap is positive when GDP is below potential). We acknowledge that these two variables may not have a completely linear relationship with P/E multiples. For example, a deflationary environment probably would not lead to higher P/E (despite the negative correlation between P/E and inflation). However, our 2010 headline CPI forecast equals 1.2%, a rate within our historical regression sample set. The standard error of our model is 3.4 points, indicating the regression results should not be interpreted with a false sense of accuracy.

(3) Comparison with DDM (13.1x) and Fed Model (16.4x)
Independent valuation models provide varying implications for year-end P/E multiples. Our 2009 year-end price target of 1060 stems from our Dividend Discount Model (DDM) and implies a year-end 2009 P/E multiple of 13.1x, based on our 2010 pre-provision and write-down EPS estimate of $81. This result represents the lowest implied P/E of our various approaches. The Fed Model suggests P/E multiples may expand significantly in the near term, rising to 16.4x by year-end 2009. This model suggests equities are undervalued relative to bonds. The usefulness of this methodology in the current environment is limited given the unprecedented government actions that have kept interest rates unusually low.

P/E is hard to target; using 15x long-term average is too simplistic
Most investors agree with a $75-$80 EPS estimate for 2010. Bullish investors argue for 15x P/E multiple based on long-term history, and a year-end 2009 target of 1200. Our year-end 2009 price target remains 1060. We recognize the possibility the S&P 500 could rally sharply in 4Q boosted by better than expected earnings results and increased risk appetite. However, we reject the argument of many investors that re-valuation alone will propel the market higher through multiple expansion back to the long-term average.

To see the full report: PORTFOLIO STRATEGY