Our economics department, headed by Michael Knox, commented last week on the potential for a substantial rally in the US S&P 500.

They noted that, coming into the current US earnings season, there were widely differing views about what the results would be. Top-down estimates prepared by economists and strategists thought that operating earnings would come in at US$17.42 per share. This review was influenced by the current popular pessimism about the US economy. Bottom-up estimates prepared by equity analysts thought that operating earnings would be better at US$19.68 per share. Both were wrong.

With a third of companies reporting as at 21 July, the estimate for the second quarter of 2010 has risen to US$20.03 per share. This is 5.5 per cent higher than the earlier estimates. The best performing sectors so far have been financials where earnings have been 16.9 per cent higher than anticipated, industrials where earnings have been 11.8 per cent higher than anticipated, and information technology where earnings have been 10.2 per cent higher than anticipated.

An estimate of US$20.03 per share for the second quarter of 2010 brings total estimated operating earnings per share for the four quarters to June 2010 to $US72.35 per share. The bottom-up estimate for operating earnings per share for the third quarter of 2010 is US$27.02.

Including this estimate, this brings the 12-month rolling operating earnings per share for the year to September to US$77.29.

Our model of the S&P 500 is based on 12-month rolling operating earnings per share and US 10-year bond yield. Our model explains 77.4 per cent of monthly variation in the S&P500 from July 1988 to July 2010. Our estimate of earnings per share for the year to September of US$77.29, together with the US 10-year bond yield of 2.96 per cent, gives us a model estimate of 1465 points. This is 363 points higher than the actual traded value on 27 July of 1102 points.

The S&P 500 appears to be deeply undervalued.

The S&P 500 swung wildly around fair value in the 90s. A deeply undervalued market in the late 80s and the middle of the 1990s was replaced by a market that surged to speculative excess at the end of the 90s. The past 10 years have seen an S&P 500 much better behaved. This market has followed much more closely its appropriate value in terms of earnings per share and bond yield.

Still, we have seen some dramatic swings around fair value. These swings have been particularly evident in the past two years. Back in February 2009, our indicator reached a low at 1.12 standard errors below fair value. The market then rallied dramatically reaching a peak of 0.77 standard errors in excess of fair value in September 2009. Concern about sovereign debt issues has seen the S&P 500 slump to a low of 1.15 standard errors below fair value in June 2010. This made it actually slightly cheaper than the low in February 2009.

Recent weeks have seen a rally in the S&P 500. However, the result has been to only move the market up to a level where it is still 1.08 standard errors below fair value. In terms of our indicator, this is the third most undervalued level that the market has seen in the past decade.

We expect the S&P 500 to continue to rally towards fair value over the balance of 2010.

Note: The data on earnings per share used were sourced from the website of Standard & Poors. The models used are our own. Our conclusions are especially our own.

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