Our Quarterly Commentary
Information on this site is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Tarpley & Underwood Financial Advisors, LLCFirst Quarter 2009
The above assumptions give an estimate of S&P 500 earnings of about $51 five years out. To this earnings number is applied two valuation multiples. In one case is assumed a P/E multiple of 16x. This is roughly the multiple observed in the period after the earnings trough during the Great Depression. In the other case, a lower multiple of 13x is assumed to account for the possibility that market psychology may be depressed if the worst case economic scenario plays out. There are other macro risks as well, such as dollar depreciation and higher-than-expected inflation both of which might compress valuation multiples. The market has experienced P/E multiples lower than 13x, but that has typically been during periods of high inflation (the 1970s), world war, or when earnings are growing very rapidly (e.g., after World War II) – none of which are expected five years from now in this scenario. This multiple appears to be sufficiently pessimistic as an end-point multiple. That does not mean the multiple couldn’t drop below 13x at some point during the next five years.

Multiplying the P/E multiple and the estimated earnings number gives an estimated S&P price level five years from now. The return expectation is then made by calculating the annualized price return and adding the estimated dividend yield. From the quarter-end S&P level of around 800, five-year estimated returns in this scenario are not attractive (roughly -1% to +3%) though not a disaster. While we don’t believe the most negative scenario is the most likely outcome, we believe it could occur and that it deserves to factor into our investment decisions. It is a key reason why we remain underweight to stocks despite their huge declines over the past 17 months.

The Optimistic Scenario
In the most optimistic Goldilocks scenario (Scenario 4), the assumption is made that S&P earnings revert to their long-term earnings trend line five years from now. Prior to the events of last summer when the financial crisis began to intensify this was the baseline scenario. That is, the outcome which was assumed to be the most likely outcome that we would experience in a normal recession/expansion cycle and so the estimate was that in five years time earnings would be at or in the neighborhood of their very long-term earnings trend line (which reflects a 6% long term average annual growth rate going back to the 1920s). However, given the deleveraging process as well as the potentially challenging longer-term consequences resulting from the current government intervention, this scenario is viewed as less likely than the more negative scenarios, but still one that is reasonably
possible and that therefore deserves to factor into our decision making.

This scenario generates an earnings number of around $86 five years out. We apply an 18x P/E multiple, which is consistent with long-term historical average P/Es during periods of moderate inflation and normal economic growth. From the S&P around 800, this scenario suggests a stock market return of around 17% per year over the next five years. Such a return would be very attractive in both absolute terms and relative to other asset classes and is a key reason why we are not more underweight to equities than we currently are.

The Other Scenarios
The other two scenarios generate potential returns that fall between Scenarios 3 and 4. We won’t go into the details here, but qualitatively, both scenarios assume earnings growth better than the worst case scenario although still not as strong as in a normal cycle. The end-point earnings estimate for Scenario 1 is about 30% above the worst-case and for Scenario 2 it is about 25% higher. The endpoint P/E multiples in these scenarios is based on a variety of factors. One factor is  that the very long-term average P/E going back to the 1920s and eliminated the extreme outlier multiples during the tech bubble in the late 1990s. A second consideration was the relationship between P/E ratios and inflation. Finally, the potential for P/E contraction due to higher investor risk aversion as this market cycle plays out. Putting all of this together led to lower multiples (14x to 15x) than used in the optimistic scenario. With the S&P currently around 800, these scenarios imply market returns in the 5% to 8% range—decent but certainly not compelling enough to warrant a tactical overweight to stocks.

Extending Our Time Horizon
We want to emphasize that there will be a recovery in earnings at some point and we believe investors with a very long time horizon (greater than five years) should do at least okay owning equities at current prices and likely better than bonds. And as we extend our investment time horizon out towards 10 years, our expectations for equity returns move toward the more optimistic end of our range, in the upper-single-digit to lower-double-digit return range. This is because earnings and P/E multiples are more likely to normalize (revert to their long-term trend lines or averages) as time goes on and the global economy heals itself. But the path from here to there is likely to be bumpy and there will probably be some big dips along the way. When stocks do become sufficiently undervalued in the short term, we will look to opportunistically add to our equity exposure in order to generate higher long-term returns for our clients’ portfolios.