Written by Michael Knox, chief economist, RBS Morgans

In spite of the recent rally, US equities remain surprisingly cheap. US earnings are at the highest level ever, exceeding that of 2007.

With 47.6 per cent of earnings reported for the fourth quarter of 2012, companies in the S&P500 are estimated to have earned US$24.35 per share. This is slightly lower than the estimate before earnings season began of US$24.77. Including earnings for the March quarter of 2012, 12-month rolling operating earnings per share now rises to $US98.05 per share. The path of 12-month rolling operating earnings per share is shown in Chart 1 below. We can see that the March level of earnings is expected to be an all-time record.

It is higher than the previous cycle high of US$91.47 for the year to June 2007.

In Chart 2 below, we see our updated model of the S&P500. This gives us an appropriate level for the S&P500 based on its historical relationship with 12-month rolling operating earnings per share and US 10-year bond yield. Our model explains 73.1 per cent of monthly variation in the S&P500 over the period from March 1988 up to and including January 2012.

US 10-year bond yields on 1 February were only 1.83 per cent. This low bond yield combined with a high level of earnings per share, gives our model a high estimate of appropriate value. Our estimate is now 1681 points. This was 357 points higher than the close of the S&P500 of 1 February of 1324 points. In spite of the recent rally, the S&P500 remains remarkably cheap.

In Chart 3 below we see our overbought/oversold indicator for the S&P500. This shows us the difference between the actual level of the S&P500 and the level estimated by our model. The difference is shown in standard errors. Showing the difference in standard errors allows us to compare it with other times since the late 1980s. On 1 February, the S&P500 was 0.8 of a standard error below fair value. This compares to the level of 0.89 standard errors below fair value in February 2009 at the bottom of the financial crisis.

It is interesting that market participants were even more pessimistic on equities at the end of 2011 than they were in the global financial crisis. Even though equity prices have risen a long way from their low last year, the current level of pricing is still relatively pessimistic. US equities remain very much undervalued. There is much more upside still to come.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.