Stock Market Valuation

The momentum of earnings recovery has eased substantially from a torrid pace but is still solidly
on track. Inflation pressures are moderating. With this immediate backdrop, the SP500 should
be trading for about 16.5x estimated 12 mos. net per share through Sept. or roughly 1550.

With global economic recovery two years along, further earnings progress is now far more
dependent on top line growth than profit margin expansion. Global leading economic indicators
peaked in positive momentum in Feb. this year. The global measures are still positive, but are
far more subdued going into Sept., which portends a sharp deceleration of economic growth
particularly for manufacturing and production. US indicators are in synch with the global trend.

Since the Spring of 2010, when leading indicators suggested a slowing of growth, the stock
market has been more sensitive to leading measures than to coincident measures. This focus
has lead to a substantial contraction of the SP500 p/e ratio, as strong earnings performance
has been offset by a growing sense of investor pessimism about the future. Specifically,
the p/e of 17.7x seen in early 2010 has eroded to 12.5x today. Moreover, the p/e ratio is
not just hit or miss the fair value level of 16.5x, but is trending down to reflect an increase
of investor guardedness about the future.

Now, earnings progress for the SP500 has outpaced that suggested by the leading indicators.
To add to the issue, earnings progression has been far smoother than the leading indicators,
which have been rather volatile. These developments  plus a trend of increasing investor
pessimism make it difficult to say with confidence where the market should be trading today
and even tougher to say where it should be a year out.

The market is very reasonably priced when viewed in longer term perspective, and it has
sizable upside on improvement in shorter term fundamentals. However, experience in this
economic recovery shows clearly that the shorter term leading economic indicators and,
perhaps, the Fed have to be at your back. With an important Fed meeting ahead and the EU
wrestling to save their union now foundering around a prospective Greek default, be careful
to give the market a few weeks to sort this out in your thinking.