Market Valuations Appear Troubling

Given that we are in the middle of 4Q12 earnings season we wanted to point out an alarming trend that we are seeing.

Earnings Results

Starting with earnings results for the last quarter, we have seen roughly 30% of the companies in the S&P 500 report and analysts are expecting almost 3% earnings growth year over year. That is an improvement from 3Q12 but still pretty anemic.

We can attribute the soft 4Q12 earnings results on two events in our opinion. First, Apple (AAPL) has been somewhat of a drag on the numbers for the final quarter of last year.

Additionally, we are most likely seeing a drag on earnings due to the uncertainty created by the fiscal cliff negotiations of late last year.

That can be seen in today’s durable goods figures. While orders for big ticket items jumped 4.6% in December, when you carve out the transportation sector orders increased 1.3%. Durable goods orders ex-transports and military (excluding the most volatile components) we saw a weak 0.2%. It appears that the private sector refrained from cap-ex spending in the latter part of last year.

That said, we like to avoid the quarter to quarter fluctuations in earning results and attempt to value the market based on twelve-month forward earnings expectations. As of last week, analysts now expect the S&P 500 to earn $112.52 per share. That places the index 13.3x forward earnings.

This is where it gets interesting

Based our analysis, our fundamental model encompasses several valuation metrics in an attempt to arrive at a fair value for the US indices.

The key elements within our fundamental model focus on:

1 - The twelve-month forward earnings yield for the S&P 500 (which is the inverse of the twelve-month forward P/E ratio).

2 - Expected earnings growth over the coming twelve months.

3 - Yield differential against the ten-year treasury yield to attempt to capture security rotation.

Based on the above valuation metrics and the 10-year Treasury yield sitting around 1.8% we are putting fair value for the S&P 500 at $1563.

There are no such things as coincidence.

Based on the fundamental model, the new fair value for the S&P 500 places our end point at the top of a major fifteen year cycle. As can be seen in figure 3, our fair value figure sits at critical resistance levels.

Bottom Line: We continue to be long this market but have been issuing warnings as to the strength of this rally for several weeks. It is our opinion now that the stock market will most likely see a major correction as the S&P 500 approaches this critical resistance level. We will readjust our portfolio weightings as market action dictates.

-Joseph S. Kalinowski, CFA