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Chuck Carnevale

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S&P 500: Modestly Overvalued

Chuck Carnevale - Wednesday, January 06, 2010

After a strong price recovery in 2009, the question on every investor’s mind is what about 2010? To us, it’s always a function of valuation based on earnings. In fact, the correlation between earnings and price explains a lot about past, present and ultimately future performance. This is true for individual companies, but applies to indices as well.

In Figure 1 below we look at the S&P 500 since calendar year 1996. This is just before the infamous irrational exuberant period that ended in 2000. Note how dramatically overvalued the S&P 500 had become. The black price line should be touching the earnings line at the 20-year historical normal PE ratio of 17.5. As can be seen the inevitable reversion to the mean occurred as price fell to earnings justified levels.

After the correction occurred, the price action of the S&P 500 has closely tracked and correlated to earnings since 2003. The price following earnings is what one normally expects to see. Therefore, the importance of earnings is evident and, in our view, profoundly important.

Figure 1 S&P 500 15yr EPS Growth Correlated to Price



Price Follow Earnings

What we conclude from the above is as follows: Note that the stock price of the S&P 500 ended above its 2009 earnings justified level at a closing PE ratio just above 19 (red circle). This is slightly higher than the last 20-year average PE ratio of 17.5, and above the 80-year average S&P 500 PE ratio of 15. However, also note that the current S&P 500 stock price is lower than earnings estimates for year-end 2010 justify. The bottom line is that we believe the general stock market today is modestly overvalued.

On the other hand, a 20-year historical normal PE ratio of 17.5 times 2010’s estimated S&P 500 earnings of $73.50 implies an S&P 500 fair value of 1,286.25 by year end. This is obviously above its current value at close of business on 1/4/2010 of 1,132.99.

Therefore, assuming the forecast is reasonable, the S&P 500 has only modest upside for calendar year 2010 based on normal valuations.

On the other hand, there is not a great deal of risk in the index either. Once again, this hypothesis is based on the 2010 earnings forecast being reasonably accurate.

In the Final Analysis



We believe that understanding and recognizing the relationship between earnings and price is vital to long-term investing success. When price is above what earnings justify, caution is called for. However, when price is below what earnings justify, opportunity is usually manifest. In the long run earnings determine market price.

Today’s article is based on the S&P 500 considered a good proxy for the market in general, also referred to as the averages. In future articles, we will feature strong above-average individual companies that we believe remain undervalued opportunities.

We contend that it is a market of stocks rather than a stock market. Therefore, focusing only on what the market in general may or may not do can be very distracting for investors. What you actually invest in is ultimately more important than what the averages may do. We suggest seeking out above-average businesses at or below fair value as a formula for successful investing.

 

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"Chuck - Thank you for your well thought out articles. I tend to be a visual type of person so I really appreciate the F.A.S.T. Graphs™ approach."


"Great article, as always! I always look forward to your articles, and am especially eagerly awaiting your next in this series. I find the F.A.S.T. Graphs™ extremely helpful."


“Your F.A.S.T. Graphs™ put all of this in a single artful picture and the accompanying spreadsheets hammer home the point.”


“I use the F.A.S.T. Graphs™ method to evaluate all of my ideas. I recommend it for individual investors, since it helps them focus on data and get past the many emotional arguments.”


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“Thanks, Chuck, for your F.A.S.T. Graphs™. Each of these graphs is worth 1,000 words in describing a company's growth, consistency and valuation. Thanks for sharing your graphs.”


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    Testimonials

    “I appreciate your work, Chuck. As a subscriber to FAST Graphs™, I use the tool to decide on whether to purchase additional shares of what I currently hold or to add a new holding. Your articles help me make full use of the tool and give other readers valuable information, if they take the time to learn. One of the biggest enhancements that I use is the FFO data added for MLPs and REITs.”


    “When FAST Graphs™ were unavailable because of Hurricane Sandy, I realized how much I need them in order to make investment decisions.

    (Wish I could be) Long FAST Graphs!!!”


    “One more vote for the value of FAST Graphs™; just started a subscription to Chuck's great service (premium), and am having a ball analyzing so many stocks quickly.”


    “I feel very ill-equipped to make investment decisions without Fast Graphs. :-)”


    “Yesterday, I signed up for your F.A.S.T. Graphs™. It's a really amazing, valuable tool for checking over/undervaluation of stocks. Wish I had it years and years ago!!”


    “Love the F.A.S.T. Graphs™: One glance and you know a whole lot.”


    “About Chuck's F.A.S.T. Graphs™: They are invaluable to me in making decisions about the stocks I own (in addition to what you are saying about doing other research) and the ones I hope to own in the future.”


    "Chuck -- Your proprietary F.A.S.T. Graphs™ are a VERY impressive tool!"


    “If there were an Investor Hall of Fame for people who have helped others with their investing, and sharing valuable information, you and your F.A.S.T. Graphs™ would get one of my selections.”


    “I love Chuck's F.A.S.T. Graphs™! Well worth the price of admission for what he gives you.”


    "Chuck - Thank you for your well thought out articles. I tend to be a visual type of person so I really appreciate the F.A.S.T. Graphs™ approach."


    "Great article, as always! I always look forward to your articles, and am especially eagerly awaiting your next in this series. I find the F.A.S.T. Graphs™ extremely helpful."


    “Your F.A.S.T. Graphs™ put all of this in a single artful picture and the accompanying spreadsheets hammer home the point.”


    “I use the F.A.S.T. Graphs™ method to evaluate all of my ideas. I recommend it for individual investors, since it helps them focus on data and get past the many emotional arguments.”


    “I recently subscribed to the F.A.S.T. Graphs™, and these articles are helping me learn how to better use them. They really do give you a good quick look at the valuations picture. A much needed tool!”


    “I also always appreciate the clear-cut information provided through your F.A.S.T. Graphs™ and articles.”


    “Thanks, Chuck, for your F.A.S.T. Graphs™. Each of these graphs is worth 1,000 words in describing a company's growth, consistency and valuation. Thanks for sharing your graphs.”


    “Thanks, Chuck. Love the F.A.S.T. Graphs™! It makes investing so much more clear.”


    “Chuck's F.A.S.T. Graphs™: They are invaluable to me in making decisions about the stocks I own (in addition to what you are saying about doing other research) and the ones I hope to own in the future.”


    ”I am amazed at the usefulness of your F.A.S.T. Graphs™ and I plan on using them for a long time to come.”


    “Chuck's F.A.S.T. Graphs™ will give you a tool to find those well chosen stocks...”


    “Thanks for the F.A.S.T. Graphs™, Chuck. They are the best tool I've used.”