S and P valuation

I'd like to return to a theme I've addressed in prior posts and talk about the market valuation. Now, we have seen that interest rates have stayed low and for the 10 year treasuries are still below 4%. Since they are considered extremely safe investments they are a good starting point. If you are going to invest in a stock, you are taking on risk that simply doesn't exist in a treasury bond. Because of this risk, you probably want to get at least 50% more in earnings (not dividends but earnings) from a stock investment. So that would mean a return of about 6%, or a P/E of 16. Even if you use 15 instead of 16, this means that if you multiply the S&P earnings by 15 you should get an approximate valuation.

Now we have had a surprisingly good earnings season. Now as of Aug 4th, the current S&P estimate for 2009 and 2010 is 54.28 and 73.18 respectively. If you look at the current year estimate (and note the estimate shows earning increasing each quarter) you would come up with a market valuation in the low 800s. If you consider 2010 projected earnings you would get to about 1100.

Based on recent data, I believe there is sentiment that the earning may increase faster than the projections. After Friday's rally the S&P is just a little over 1000. If the market actually looks 6 months ahead, we would be about 20 points higher than the first quarter of 2010 estimate would indicate. Of course if you think the estimates are low, the market may be undervalued. However, since earning estimates are projected to go up each quarter in 2010, unless there is some specific bad news, I would expect the S&P to go up to 1061 next quarter.

A lot of commentators think the S&P has gone up to far and too fast and expect a pull back. The numbers don't support that position and in fact say the S&P is almost exactly where it should be. Now, if you don't believe the earnings or the estimates, that is a different story.

Which brings me to my next point. I hear commentator after commentator make a comment similar to the following :
"These earnings are due to cost reductions and are a one time event"

I think the people making these comments are intelligent but I simply can't figure out what they are trying to say. Cost reductions are not restructuring events, they are in fact ongoing. Once you eliminate cost and achieve earnings at a particular revenue level, you will continue to earn at that rate if the revenue level stays the same. Now if the revenue grows, you may or may not have to reintroduce cost and if we have any kind of recovery at all, I would think cost will be introduced at a lower rate than revenue will increase, leading to very good earnings growth.

I have heard some analysts say something that does make sense to me. Companies have used this downturn to eliminate jobs that they perceived to be of limited value. I believe many of the jobs cut will never be replaced, no matter how fast the economy grows, because companies will use this opportunity to either outsource them or replace them with automation.

I have discussed the need for the country to get behind the renewable energy growth engine to create jobs, but that is a different post.