A 2010 equity portfolio: where the US market stands now

Facts and figures from the 2009 stock market

The S&P 500 ended 2009 at a level of 1115.  This represented a gain of 26.5% on a total return basis for the year.  Capital change made up 23.5% of that and dividend payments 3%.

The median stock was up 29% or so, meaning that smaller capitalization issues outperformed their larger brethren.

Recovery from the market lows of early March was even more dramatic, with the index up 67% since then.  The rise represents a reversal of about half the market losses since the highs of 2007.

S&P estimates earnings for 2010 on the 500 index at about $76, meaning the benchmark stands on a p/e ratio of 14.5x expected year-ahead results.  Value Line, which uses a very different methodology in estimating a market p/e, arrives at a roughly equivalent result–one suggesting also that smaller stocks are now trading on somewhat higher p/e ratings than large caps.

The prospective dividend yield on the market is 2%.

What they imply for 2010

Multiples are no longer at the give-it-away-for-free levels of March, but they’re not really expensive, either versus history or versus other asset classes.  At the moment, cash returns effectively nothing.  And the stock earnings yield (the upside-down p/e that academics prefer) of 6.9% compares favorably with the 10-year Treasury coupon of 3.9% and the 30-year of 4.7% (both of which will likely rise as the year progresses).

Over the past several months, S&P has steadily been revising the $76 figure upward.  If history is any guide, it will continue to do so.  Why is that?  Several reasons:

–the effect of operating leverage (the outsized effect on earnings of small changes in revenues) is notoriously difficult to forecast around turning points in the economy,

–analysts don’t want to look foolish by publishing numbers that turn out to be too high,

–institutional customers want conservative figures and probably won’t trust anything else,

–companies are doubtless exerting their usual pressure on analysts to conform to company “guidance” that leaves room for positive earnings surprises, and

–most earnings estimates originate in New York, the epicenter of the financial meltdown, where people are gloomier than elsewhere in the US (except possibly for the large bonus-collecting bankers who created the problems).

Editorializing aside, the first reason, operating leverage, is by far the most important factor.

If we figure that the actual eps number will end up being, say, $80, then the market is trading on under 14x earnings for 2010.

A 15% advance for the market this year?

I think it wouldn’t be at all unreasonable to think the S&P could rise by 10%-15% from here by yearend.  That would mean a rough target for the market of being at 1225-1275 in December.

How the bull market has played out so far

You can find what I’ve written about bull markets in my posts from the first half of last year.  In addition, I recently came across an excellent article on the subject written by Sam Stovall, the chief equity strategist for S&P.  It’s short and well worth reading.

On page 6 of the article, Mr. Stovall presents a chart in which he has compiled the performance by sector of the S&P 500 in the first year of recovery from every bear market (ten of them) since World War II.  He has also aggregated the results, so we can see what the average performance of sectors and the market has been.

Three points in particular stand out to me:

1. The rebound from the lows this time has been much faster than from prior bottoms.  Recovery from the second oil shock, up 52% in the first year, is the closest to the 2009 performance.  The average first-year bounceback was 33%.

2.  Sector returns are more widely dispersed in the current return than in earlier ones, especially for sectors that have underperformed to date.  For example, relative to the index return, defensive sectors have performed as follows:

——————–2009————-average bull market

Telecom                  -38%——————- -13%

Utilities                  -30%——————- -11%

Staples                   -24%——————– -4%

Healthcare                  -22%——————- flat.

Among the outperforming sectors, Materials is the only outlier.  This sector is up 19% more than the index vs. a typical performance of flat.  (I’ve excluded Financials from this list because of their most unusual performance during this cycle.)

Another sector I find interesting is IT, which is up a lot, but at the index +15 percentage points it is about in line with its recovery average of the index +16.

What does all this mean?

I think the numbers say that the lagging sectors are so far behind the index that at some point they are going to have to play catch up.   A trader would doubtless want to overweight the laggards in hopes that a rally will come soon.  My preference would be to keep these sectors at neutral weight and be prepared to underweight them if/when they show a period of relative outperformance.

I find the technology performance reassuring.  IT is a sector I like, but I’ve been bothered a bit by the fact that it is fast approaching 20% of the market, a relatively large size for any sector.

Growth vs. Value

In the first year of a typical upturn, value stocks outperform growth stocks.  The Stovall research shows this same pattern continuing during the current upturn.  In fact, 2009 shows the sharpest outperformance for value of any bull market listed.  This would seem to imply that the stock market is trumpeting the start of a vigorous economic rebound that will carry even the most commodity-like firm along with it.  I don’t think that’s correct.

The numbers for the bull market so far are certainly correct.  But if we take a slightly different time frame, we see a somewhat different picture.  Looking at full-year 2009, we see significant outperformance of growth over value.  Why the difference?

Bank stocks are classified as value stocks.  They’re the  sector that cratered in early 2009.  They rebounded by 135% through November, possibly creating the illusion of a value stock market when, ex banks, there hasn’t been one.

Of course, especially if you know that I’m a growth stock investor, you may be thinking (as I have been while writing this) that he doesn’t like what the data say so he’s manipulating the facts away.  A fair point.  It may be that the stock market is signaling a stronger upturn than the consensus expects and I’m just not hearing the message.

I’ll deal with this issue in my next post, on where I think we should be putting our equity money.  The short answer:  I’ll concede I have a point that may have questionable origins.  There’s no need for me to make this issue a keystone of my investment strategy, however.  Better to have a couple of good ideas to organize investments around and reject the rest than incorporate a dozen half-baked ones into a portfolio.

Nevertheless, I should also be on the lookout for signs that the recovery may be stronger than I, or the consensus, expect.


There’s still a lot of money on the sidelines, although it has begun to trickle back in small amounts into stocks over the past few months.  As I’ve mentioned in a previous post in this series, individual investors have been mostly absent so far from the stock market during the rebound.  They have, instead, been seeking the “safety” of bond funds, a decision that will probably cause a considerable degree of financial pain as/when the Fed begins to raise rates back to normal.

The current asset allocation is bullish for stocks, since at some point continuing reasonable equity performance will compel individuals to increase their equity exposure.

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