Wednesday, June 13, 2007

Valuation Update: Expectations of a 16% Increase in Earnings

This morning's retail sales number makes it clear that the correction experienced thus far is solely an interest rate related event. As my modified Fed Model to your left shows, at current levels (light blue) the expected return for stocks is right around zero. Clearly, investors do not believe in earning a flat to negative return. Therefore, let's look at what earnings level the market is pricing in to generate a positive return.

Assuming that rates rise another 25 basis points and taking your standard 12% expected return for large cap US stocks, the earnings needed to generate such a 12 month return for equities equates to $108 in operating earnings for the S&P 500 (lavender). That's $108 for the next twelve months, to mid 2008.

Of course, if investors believe that the market should not price in an added risk factor of 90 basis points (something it has done throughout the current bull market), then something less than $108 would generate a 12% return.

Investment Strategy Implications

Just as many bond investors have had to adjust their thinking re Fed rate cuts and the global inflation/US domestic stagflation, so, too, equity investors may have a similar adjustment process to go through should the next 12 months earnings growth not match current expectations. A key will be the upcoming 2Q07 earnings reports and guidance commentaries that should help shed light on the earnings part of the valuation equation.

At current levels, expectations of $108 operating earnings (which represents a 6 month earnings increase of 16%) seems a bit overly optimistic. Needless to say, the potential disappointment factor is quite large should earnings go the other way, say to $88 (yellow for yeow!).

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