S&P500 Fair Value Estimate - July 1, 2007
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With S&P 500 earnings continuing to grow at double-digit rates, though at a slowing pace, our valuation model continues to point to considerably more upside in the market at the start of Q3-2007.
Profit margins remain quite wide, at close to record levels, as companies have only reluctantly increased capital spending. Instead management teams in all sectors have been deploying capital through increased dividends and stock buybacks – both which should continue to support share prices. Bearish interpretation is that today’s near-record profit margins are unsustainable and that long-term profit margins of roughly 40% lower are just a matter of time. In this case, today’s P/E ratios would look substantially under-stated.
With interest rates beginning to drift upwards, the spread between 10-year treasury rates and stock earnings/price ratios tightened moderately over the quarter. Still, with earnings yields superior to treasury yields, and corporate bond spreads at extremely tight levels, opportunities remain for private equity investors to initiate corporate buyouts – and these transactions have been frequent and well-received by the broad market. As private equity firms race to go public, look for buyout opportunities to remain at a heightened level.
Based on our work, fair value for the S&P 500 currently remains 55% higher than current index levels – suggesting ample upside for today’s investors. Recognize that as of today, earnings for the S&P 500 index are roughly 57% higher than at their highest level in 2000. Since its peak in early 2000, the index itself has risen a mere 0.3%. From this perspective investor enthusiasm has remained in check throughout this market rally.
Assuming earnings come in as currently expected by Wall Street analysts over the next year, fair valuation 1-year forward would be roughly 69% higher than current levels.
