SP500 Earnings Estimates - Who Is Right?

See below estimates:

SP500 Levels, Inflation, Interest Rates, Yield Curve etc.

Policy remains abnormal.  I would like to see the nominal fed rate rise towards 2.75% with inflation at 2.5% levels for normalcy as this would push real fed funds rate to just over zero which is where it belongs.  To do this without hurting nominal GDP rate would require that long maturity & bonds don't shoot up in proportion. 

Yield Curve, Inflation, Nominal Reverse Repo Rates, Real Reverse Repo Rates, GDP Growth Rates & Sensex

The yield curve remains inverted. It is likely the yield curve inversion is caused partly by the lack of depth in corporate debt markets. In addition, the long term nominal interest rates need to go up to remove the inversion – long maturity rates will only increase, once the structural change in the global economy is recognized - watch the red dotted line; that shows the inflation trend based on median 6 year inflation rates – it's up and has been rising for a long time. It is likely that we will be in an environment of higher inflation and interest rates for the next several years. Watch how the rate of increase in the red dotted line elevates starting April 2009; that recognizes the impact of the large increase in global money supply. Going ahead the long term inflation trend based on median six year inflation, is likely to partially reverse as money supply shrinks once the process of global deleveraging commences in earnest – expect trend inflation to fall from 8% now to 6% to 6.5% over time.

Immediate Risks, Mitigating Factors and Where Markets Might Go From Here

India

Risk: Inflation a problem. 

Mitigating Factor: RBI is handling it well, hopefully they allow for the lag affect of monetary policy and back off before inflation starts falling. 

Impact: Rising interest rates, moderating inflation and slower growth. 

Conclusion: The problem is not interest rates but growth expectations, interest rates are still below long term average real rates. Consensus earnings growth estimates have fallen considerably, but need to fall further. My guess of FY12 EPS for Sensex is around 1,150 and this supports a value of 18,600 even though intrinsic value remains lower at 14,000 and fair value lower at 9,400

The Dance of the Bhaloo

During the 2^nd quarter of 2011, Sensex retreated on cries of "Bhaloo Aya, Bhaloo Aya - Bhaago, Bhaago". In terms of valuations, the market is trading near decade median level multiples of prior, current and forward year earnings. Looking at multiples of cyclically adjusted earnings (CAE 6 year median earnings), its trading at where it has traded 42% of the time based on current year CAE, 62% of the time based on prior year CAE and 44% of the time based on forward year CAE. Overall, valuations are normal – neither expensive, nor cheap.

SP500 at 2,000 by Mid to End 2012?

James Altucher recently came up with 10 reasons why the Dow could hit 20,000 (or SP500 2,000) in 12 to 18 months. You can read about it here.

Is this possible by June 2012 to December 2012? By that time, assuming SP500 2011 has delivered 95 in earnings and 2012 expectations are at 101.5 with 2013 expectations at 108. During 2012 the SP500 at 2,000 would trade at 21X prior year operating earnings (the market has traded at these multiples 18% of the time during the past decade), 19.75X current year operating earnings (the market has traded at these multiples 25% of the time during the past decade) and 18.6X forward year operating earnings (the market has traded at these multiples 39% of the time during the past decade).

During 2012 the SP500 at 2,000 would trade at 24X prior year cyclically adjusted operating earnings (the market has traded at these multiples 12% of the time during the past decade), 24X current year cyclically adjusted operating earnings (the market has traded at these multiples 6% of the time during the past decade) and 22.4X forward year cyclically adjusted operating earnings (the market has traded at these multiples 28% of the time during the past decade).

At 2,000 the SP500 would no doubt be expensive, but certainly within the realm of possible outcomes, particularly if aggressive risk taking commences.

What would a market at 2,000 indicate as far as investor expectations are concerned? With EPS at 101.5 for 2012 and assuming a long term nominal earnings growth rate of 6.5%, an investor seeking long term returns of 9.75% annually assuming a 40% payout ratio, would result in an intrinsic value of 2,000 (fair value would be 1,250). Keep in mind that data starting from 1871 indicates that:

• A 40% payout ratio is consistent with nominal earnings growth of 6% to 7% and
• The annual investor return (including) dividends earned by investors has been 8.6%.