The 2011 US Stock Market Outlook Looks Bright

Thursday, December 9, 2010

One year ago, the Dow Jones Industrial Average (DJIA) was around 10,300. Today, it’s about 11,400, for a gain of over 10% (excluding dividends). Nice. Except, it actually underperformed its fundamentals. Its improved valuation gives us the prospect of a very happy new year indeed. Here’s why…

It starts with earnings

2010 has been a year of unexpectedly positive earnings surprises. As a result, analysts have raised the DJIA’s estimated 2010 earnings from $778 in late November 2009 to today’s $844 – an increase of 8.5%.

Looking at the DJIA price level, we can see investors in November 2009 were willing to pay 13.2 times earnings (i.e., 10,300 divided by 778). Today, the DJIA is at 13.5 times earnings (11,400 divided by 844). That looks like the stock market maintained its value, except…

… time marches on and needs to be accounted for

When investors valued the DJIA stocks last year, 2009 earnings were still estimated and there was great uncertainty about the economy, financial system and corporate earnings. Today’s investors know a great deal more, and the uncertainties have diminished. So, we would expect the price/earnings (P/E) ratio of 13.2 to have increased, but it has barely budged.

More importantly, the more direct comparison is not what investors are willing to pay for 2010’s earnings, but how they value 2011’s. Analysts anticipate 2011’s earnings to be about $938, meaning the DJIA, at 11,400, is selling at 12.2 times earnings, a lower price (valuation) than last year’s 13.2 ratio.

Naturally, the question is “why?” To answer, we can divide the year into three moves. (1) The rise through April saw a positive shift in investor buying and a P/E ratio increase to 14.2 times; (2) Then the May/June “mega-trend” risks hit (Greece etc.) that reversed investors’ stock interest, sending the DJIA down to a low 12.2 P/E ratio; (3) A fundamental-driven rise (August was a mini-reversal), cleared the three hurdles I have discussed previously.

Because investors have not resumed their buying and mega-trend worries keep hitting the headlines, the stock market retains its lower pricing.

The components of stock return

Every year, a stock’s return is influenced by these factors:

  • Fundamentals – The actual results the company’s activities (both expected and unexpected)
  • Forecasts – Anticipated results (which can be influenced by the actual results)
  • Investment trends – The popularity (or unpopularity) of stocks in general, a type of stock, an industry or a particular company
  • Investor emotions – A shift between optimism and pessimism

Calculating the stock market outlook for 2011

With the facts we know, along with an understanding of history, we can now calculate a range of potential outcomes for 2011. Importantly, when we look at valuations, we will need to take 2012 into account. One year from now, that is what Wall Street will be focusing on to value stocks.

A range of possible 2012 earnings…

Here is the backdrop for creating 2012 earnings forecasts:

  • 2010 earnings: $844 forecast with likelihood that fourth quarter will once again produce positive surprises, moving the actual amount up further
  • 2011 earnings: $938 forecast. Without unexpected adverse economic conditions, will likely rise throughout the year, following the typical pattern
  • 2012 earnings: These won’t begin to be forecast in earnest until next year, but we can look at various growth estimates

And here are the calculated 2012 DJIA earnings using a range of reasonable growth rates:

  1. 2011 forecast unchanged + 2012 shows no growth = $938
  2. 2011 forecast unchanged + 2012 growth of 5% = $985
  3. 2011 forecast rises 5% + 2012 growth of 5% = $1,034
  4. 2011 forecast rises 5% + 2012 growth of 10% = $1,083

… valued at three levels

2010’s bottom P/E ratio of 12.2 times was, indeed, a low level. It represented an earnings yield (earnings divided by price) of 8.2%, typically not seen except when interest rates are high. A more appropriate level for the current fundamentals is probably about 13.5 times. When the stock market is at a “normal” level (meaning normal conditions for the economy, economic growth, financial stability and investor interest/emotions) a reasonable P/E is about 15 times. These three levels can give us a range of DJIA valuations and, hence, return outlooks.

Here are the four 2012 earnings forecasts from above, showing the rate of return, excluding dividends, produced at the three P/E levels: 12.2, 13.5 and 15:

  1. $   938 –           0%         11%         23%
  2. $   985 –           5%         17%         30%
  3. $1,034 —         11%         22%         36%
  4. $1,083 —         16%         28%        43%

So… We are at an unusual time. In spite of 2010’s uncertainties and bouts of fear, the economy and financial system have shown improvement. Also, even with slow growth and excess capacity, companies have produced better-than-expected earnings, pushing the stock market up. Yet the investor boycott of US stocks continues, keeping valuations at attractive levels. As a result, the return/risk ratio appears tilted in favor of stock investors, making the 2011 stock market outlook bright.

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