We believe that the proximate cause of the US equity market's weakness in the fourth quarter of 2007...
We believe that the proximate cause of the US equity market's weakness in the fourth quarter of 2007 and the early days of 2008 is that it has begun discounting a recession here. In fact, the market is behaving as though a US recession is a virtual certainty.
While we disagree that it is a foregone conclusion, recent developments have led us to believe that the odds that we are already in, or on the cusp of, a recession are now greater than 50/50.
But from a pure valuation standpoint, our analysis suggests the current fair value multiple of the S&P 500 is about 18.5x earnings, based on the following assumptions: one, long-term earnings per share growth of 6%; two, return on equity of 16%; three, weighted-average cost of capital equal to the 10-year Treasury note yield plus an equity risk premium of 4%; and four, a 20-year competitive advantage period (CAP), which is our estimate of the length of time that the S&P 500 as a whole will earn returns in excess of its cost of capital.
Our fair value estimate of 18.5x earnings for the S&P 500 compares to year-end P/Es for the index of 16.7x and 14.7x for 2007 and 2008, respectively, based on bottom-up, cap-weighted consensus earnings estimates. This implies market undervaluation of better than 10% on 2007 estimates and more than 20% based on 2008 figures.
That said, we believe 2008 could well turn out to be a volatile and difficult year. The market is currently weak and could remain so through the first quarter.
On the other hand, investor sentiment, as measured by the American Association of Individual Investors survey data, is about as pessimistic as it ever gets, suggesting that a powerful rally may be in the offing.
On balance, market valuation is quite supportive of higher prices, in our view. A near-term key to the direction of the market is satisfactory resolution of turmoil in the mortgage market. Easing of tensions there could trigger a powerful rally in stocks, but continued turmoil could drag the economy into recession and precipitate a bear market in equities.
- US equity market remaining weak for first quarter;
- Odds of a recession increasing but still not a foregone conclusion;
- US equities posting mid- to high-single-digit returns for 2008;
- Mary Chris Gay is the portfolio manager of Legg Mason Value fund (Dublin).
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