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S&P 500 index in cheapest bull market since Reagan era

Bloomberg/ 20 Nov 12 | 12:43 AM

Even as shares fall, strategists are optimistic about gains next year. The S&P 500 will rally 17 per cent to a record 1,585 by the end of 2013, according to the average forecast

The post-election rout in US stocks has driven the Standard & Poor’s 500 Index (SPX) down so far that it would have to advance 26 per cent to reach the valuation of bull markets since John F Kennedy was in the White House.

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Investors have seen $806 billion erased from the value of American equities since President Barack Obama was re-elected November 6 in the biggest decline since May. The combination of falling stocks and rising profits as the economy recovers has left the S&P 500’s price-earnings ratio below the ending level of eight of the nine bull markets since 1962 and beneath the average of any since Ronald Reagan was in power.

Bears say the 4.8 per cent drop in the S&P 500 and valuations show investors are losing confidence that Congress and Obama will reach a budget compromise that would keep the recovery from stalling. Bulls, including the top strategists at six Wall Street firms, say that the declines are another reason to buy and that stock prices from Apple Inc (AAPL) to Dollar Tree Inc are bound to improve as earnings increase.

“The stock market looks cheap because people are way too pessimistic about what growth looks like for the next 10 years," said Brian Jacobsen, who helps oversee $208 billion as chief strategist at Wells Fargo Advantage Funds and predicts the S&P 500 will rise 47 per cent to 2,000 in 2014. “You can get big and rapid moves in the market when expectations are so low."

Concern about the so-called fiscal cliff — $607 billion of spending cuts and tax increases that automatically go into effect January 1 — overshadowed better-than-estimated profit reports from Cisco Systems Inc and Home Depot Inc last week, sending the S&P 500 down 1.5 per cent to 1,359.88. Obama began face-to-face talks with top Republicans and Democrats on November 16 after he and House Speaker John Boehner said they will work toward an agreement. Boehner and White House Press Secretary Jay Carney described the meeting as “constructive."

Even as shares fall, strategists are optimistic about gains next year. The S&P 500 will rally 17 per cent to a record 1,585 by the end of 2013, according to the average forecast. Futures on the index expiring next month climbed 0.2 per cent to 1,363 at 8:22 am in London on Monday.

Douglas Kass, the founder of Seabreeze Partners Management Inc in Palm Beach, Florida, who recommended buying stocks at the March 2009 low says the benchmark gauge may rise 18 per cent to 1,600 next year as politicians reach a budget compromise and the economy continues to expand.

“The No. 1 mistake that is being made is the old proverb, ‘Once bitten, twice shy’," Kass said in a November 14 Bloomberg Radio interview with Tom Keene. “Market participants today are incorrectly playing the last war, which took place during the budget deliberations in August of last year. Those fears are misplaced."

Savita Subramanian of Bank of America Corp says the index will rally to 1,600 on rising corporate profits and diminishing concerns about the global economy. John Stoltzfus, at Oppenheimer & Co, forecasts the gauge will climb to 1,585 and Goldman Sachs Group Inc’s David Kostin estimates 1,575, based on support from the Federal Reserve’s third round of bond purchases. Fed Chairman Ben S Bernanke pledged in September that the central bank will buy $40 billion of mortgage securities a month until the US labor market recovers.

Optimism is misplaced unless Obama and Republican leaders are able to agree on measures to avoid the mandated cuts and tax increases, according to James Bianco, president of Bianco Research LLC in Chicago.

The $607 billion burden could cause the world’s largest economy to shrink 0.5 per cent next year, according to a November 8 Congressional Budget Office report.

“Up until the election day no one had priced in a fiscal cliff because the thinking overwhelmingly on Wall Street was there wasn’t going to be one," Bianco said in a November 14 Bloomberg Television interview. “We’re only now starting to price it in and we’ve only been pricing it in for a week. If we continue to keep our pencils down, there’s going to be a lot more pain."

The economy is recovering at the slowest post-recession rate since World War II, as the housing market stagnated until this year and unemployment stayed above 8 per cent through August.

Lawmakers of both parties say they want to avoid the fiscal cliff’s economic shock while addressing the deficit. Boehner said November 16 that Republicans are willing to consider revenue- raising measures in exchange for spending cuts. Obama said tax rates should rise without specifying that the top rate must return to the 39.6 per cent stipulated.

While the S&P 500 has doubled since Obama first took office, the index’s price-earnings ratio was lower than the 16.4 six-decade average for 38 of the rally’s 46 months, as earnings surged, data compiled by Bloomberg show.

The multiple is up 35 per cent since March 2009, compared with the average expansion of 55 per cent in bull markets since 1962, Bloomberg data show. For the past 2 1/2 years, the S&P 500 hasn’t climbed higher than 16 times earnings, compared with the average ratio of 17.4 in past rallies.

The valuation rose to a high of 13.8 from 7.3 during the first 15 months of the 1982 advance that pushed the S&P 500 up 229 percent, according to data compiled by Bloomberg. In the 1990s rally led by technology companies, it almost doubled to 28.5 during the eight years.

“As a country, we go from glum to glee and glum to glee over and over again," James Paulsen, the chief investment strategist at Minneapolis-based Wells Capital Management, which oversees about $325 billion, said in a phone interview. “After the 2008 recession and the tech bubble, we’re back at glum, so what comes next?" he said. “Confidence, and the ability to rebuild it, is our biggest asset for the future."

Economists predict global GDP will increase 2.6 per cent next year from 2.2 per cent in 2012, the slowest since it contracted three years ago, according to a survey by Bloomberg. The pace of US growth will be 2 per cent in 2013, down from 2.2 per cent this year, according to the median of 98 estimates.

The tumble since Obama defeated Republican candidate Mitt Romney, with 303 electoral votes to 206, pushed the benchmark gauge to 13.7 times reported profits, lower than the 15.5 average ratio since March 2009, according to data compiled by Bloomberg. Only one bull market since 1962 has ended with a lower valuation: the six-year cycle through 1980 in which the index gained 126 per cent to 140.52, or 9.1 times profits.

The ratio averaged 17.4 during the nine rallies and ended at about 19.9. Reaching the mean level would require a 26 per cent gain in the S&P 500, holding earnings constant, data compiled by Bloomberg show. Should profits meet analysts’ 2013 projection, the index would need a 42 percent gain from the November 16 closing price. Earnings are forecast to climb to a record $110.80 a share next year, almost double what companies posted in 2008, analyst estimates compiled by Bloomberg show.

“Valuations are cheap given what we’ve seen in earnings," said Hank Smith, chief investment officer at Haverford Trust Co. in Radnor, Pennsylvania. His firm oversees $6.5 billion in assets. “Corporate America is strong, balance sheets are exceptionally strong and flush with cash. We do not believe we’ll have a contraction in earnings next year. We expect profit growth to re-accelerate in the second half of 2013."

Apple Multiple
Apple, which has fallen 25 percent from its high of $702.10 on Sept. 19 traded at 11.9 times reported profits, a 14 percent discount to its five-year average, data compiled by Bloomberg show. The ratio reached a record 23.3 times income 2 1/2 years ago, even after the Cupertino, California-based company posted record earnings in the first quarter.

Profits for Dollar Tree (DLTR), which sells everything from toys to pet food for $1 or less, will rise 24 percent in fiscal 2013, ending in January, and 13 percent the next year, according to analyst estimates. While the shares have almost tripled since March 2009, the price-earnings ratio at 16.7 is 21 percent below the five-year average.

Southwest Airlines Co. (LUV) trades 22 percent below its historic valuation, even though earnings at the Dallas-based company have surpassed analyst projections for the past five quarters and are forecast to rise 65 percent in 2013. The shares are up 4.3 percent in 2012.

Of the 500 companies in the index, 245 have price-earnings ratios below their five-year means, data compiled by Bloomberg show. That’s up from 196 at this time last year and 174 two years ago, the data show.

Bull markets “normally finish with a real burst of hyper enthusiasm," Michael Shaoul, chairman of New York-based Marketfield Asset Management, which oversees $3.5 billion, said in a phone interview. “We haven’t seen the beginning of that yet. The transition from tepid enthusiasm to hyper enthusiasm is going to be worth few hundred points in the S&P."

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