Stock Market -- Fundamentals

In Monday's post, it was pointed out that the SP500 (1488)
was closing in on fair value of 1500. That works out to a
p/e of 17.0 x twelve months of operating earnings for the
index through 3/31/07. The big change in the environment
since mid-2006 was the sharp drop of the inflation rate.
Thus, from my perspective, the run-up in the market since
mid-2006 does not represent a blow-off but a move up to
reasonable levels based on an advancing economy and a return
to a more moderate inflation level. If you were to push the
envelope a little to incorporate a 2.5% inflation rate, you
could argue for 1550 on the SP500 (2.5% represents the yr/yr
change in the "core" CPI through 3/07).

The persistent upward momentum in the market over the past
nine months also obviously reflects positive investor assumptions
about the future. The market is in the process of discounting an
eventual re-acceleration of US economic and earnings growth and
the continuation of a moderate inflation rate.

Top line growth for both industry and finance has slowed
appreciably since mid-2006. The growth of wages has accelerated
modestly, but there has been just enough productivity growth to
avoid a broad reduction of profit margins. So, yr/yr, corporate
profits could be up 4-6% through the March quarter. It is not at all
likely that the market could hold a 17 p/e if investors did not
expect earnings comparisons to improve markedly later in the year.
Analysts expect earnings to rise serially in Qs 2 & 3 of this year,
but no major breakout to new highs in quarterly earnings is projected
until the final quarter of 2007, when the SP500 index earnings are
projected to top 25.00 for a 100.00 annual rate. To get there, it
sure would appear that the US economy will have to accelerate.

On top of this assumption, comes the idea that a re-acceleration of
US economic growth will not lead to a cyclical acceleration of
inflation. This latter assumption has looked dubious for some
months now, as US productive capacity has not kept pace with
production growth potential in a faster growing environment. I have
stayed cautious on the market until I see how well companies respond to
a resumption of faster order growth rates.

Another factor to keep in mind is that the average small and mid-cap
stock is trading between 19.0 and 19.5 x earnings. In fact my unweighted
universe of 1750 stocks is trading at an average of 18.5 x earnings. This
underscores the high expectations for future growth and benign inflation built
in to the market.

More on the fundamentals later in the week.