- - Thursday, December 30, 2010


In my view, 2010 was an interesting year for the stock market, as measured by the move in the Standard & Poor’s 500, and 2011 will prove to be just as interesting to watch.

As I write this, it looks as if that index will be up 11.7 percent this year. If that holds, it will be a better-than-normal year for the index, which averaged a return of 8.7 percent over the 1989-2009 period. Though it may be better than normal, 2010 will pale compared with a number of years that generated a return better than 25 percent, but it’s also far better than the drops we experienced in 2002 and more recently in 2008. But while I am inclined to think the market will continue to perform in 2011, there are signs and suggestions that make me think it will be another good year but not a great year.

To get a better handle on this, let’s take a look at where the S&P 500 is trading on a valuation perspective and see what is going on there. Turning to Thomson One, we find the consensus earnings expectation for the S&P 500 is $83.44 per share, which is up from the recent bottom of $60.80 achieved last year but still below the recent peak of $88.18 reached in 2006.

Using the current price for the S&P 500, we find it is trading at 15.1 times expected 2010 earnings.

Without some perspective in which to frame that price-to-earnings (P/E) ratio of 15.1, it’s just a number. Looking back over the past 10 and 20 years, we see the average P/E ratio accorded to the S&P 500 has been 17.6 to 19.1 times respective earnings per share. To use the analyst lingo, the market is trading at a 16 percent to 22 percent discount to the average multiples of the past 10 and 20 years.

Some will look quickly at this current discount to the average and say, “There must be more upside” or “The market is cheap” and argue for putting more money to work in the market. As many, including myself, have come to learn, just because something is cheap does not mean it is going to rise in value. For that to happen, there needs to be a catalyst.

For individual companies, a catalyst can take many forms — new-product introductions, such as Apple’s iPhone and iPad; a strong position in a new technology, such as 4G LTE and InterDigital; a geopolitical event, such as China’s recent cut in rare-earth-element export quotas and the shares of Molycorp; and other examples. In general, these catalysts tend to result in accelerated earnings-growth expectations, which make the valuation of the company’s shares, all things being equal, attractive.

This is where things tend to get a little sticky as we enter into 2011 for the S&P 500 and the market in general. Current expectations call for the S&P 500 to deliver earnings per share of $92.69 in 2011, which represents year-on-year growth of 11 percent and would be a new peak in earnings for the index.

Not only is that 11 percent down compared to the 37 percent earnings growth the S&P 500 is on track to deliver in 2010, but there also are several head winds that leave many to question the ability of the S&P 500 to deliver what is expected of it in the coming quarters. These head winds include continued high unemployment and its impact on consumer spending; higher commodity prices for food and energy; state and local government budget shortfalls; the ripple effect associated with the dragging housing market; and more. As tends to be the case, a better sense of what the S&P 500 will deliver in 2011 will unfold in the coming months.

Luckily, as some have noted, there is always a bull market out there somewhere, and it’s our job as investors to keep our eyes peeled and our ears to the ground to ferret out these winners. Each of the three companies I mentioned above — Apple, InterDigital and Molycorp — is up more than 50 percent this year, which is head and shoulders above the S&P 500.

Have a happy New Year and good hunting in the coming months.

Chris Versace, the Thematic Investor, is the director of research of Think 20/20, an independent equity-research and corporate access firm located in the Washington, D.C., area. He can be reached at [email protected] At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.

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