Is the market fairly valued?

It’s the one year anniversary of the S&P 500 lows, and what a difference a year makes! The S&P 500 is up over 68% in the last 12 months, but clearly the tremendous opportunities that were in place a year ago are no longer there.

There are two market conditions, however, that will allow investors to take advantage of opportunities. The first is that volatility is dramatically lower. As measured by the VIX index, volatility is nearly 80% lower than it was at the time of the Lehman Brothers bankruptcy.

The second favorable condition is that correlations between assets and within markets have come down. When correlations were extremely high, and everything was going down at the same time, the only thing that mattered to investors was to have as little risk exposure as possible.

Lower volatility and lower correlations across different asset classes presents the opportunity for investors that do their homework to generate good returns. That means looking at fundamentals such as earnings, cash flow, and dividend payouts. It also means identifying long-term trends that will cause specific sectors to outperform. For example, the Technology and Industrial sectors are positioned to perform well in 2010.

But are stocks way ahead of the economy? Is the good news already baked into stock prices?

Clearly the stock market is a forward-looking mechanism that moves in advance of the economy, but it hasn’t necessarily moved too far at this point.

Economic data over the past few weeks makes the double-dip scenario seem less likely, with new orders for equipment, retail sales, and even things like hotel stays pointing to a brighter economic climate. The jobs numbers are still bad, but have shown improvement. More importantly, many individuals are feeling less uncertain about their job prospects.

Meanwhile, corporations are reporting strong cash flow and balance sheets look relatively healthy. We are starting to see businesses buy back stock, raise dividends, and increase investment for future growth – all of which are positive signs.

We always hear about historically high P/E ratios (here is a good story in today’s Wall Street Journal), but when the market is measured by cash flow (P/CF) the S&P 500’s valuation is 37% below the 12-year average and half of its valuation in 2007. P/CF has increased from roughly 4.5 in March 2009 to 8.2 today. With data going back 1998, the CF multiple has never fallen below 8.0 prior to 2008.

I believe the S&P 500 will finish 2010 somewhere between 1200 and 1250, 5% to 9% above today’s levels, but I would be concerned around 1300. Notice that I say “in 2010.” There are many uncertainties beyond 2010 that are keeping investors at bay. Because the market is forward-looking, it is affected by how far investors are willing to look into the future, which depends on their level of comfort and safety. One year ago, investors could barely look a week into the future. When a bull market is under way, investors are willing to look 18 to 24 months into the future to discount future earnings.

Some may argue that fair value is 20% below where the market stands today. I agree that buying stocks at prices 20% lower than today's would better compensate for the long-term risks facing the U.S. economy; however, I am not selling stocks because waiting for this event to occur could take several years. Markets are historically "overvalued" for extended periods of time. At the same time, ignoring the significant risks at hand is not prudent behavior either. Expectations must remain reasonable.

One year ago, investor sentiment and psyche was quite low among both individual and institutional investors. One year later, the easy money has been made, so it's important to remember that the recovery will be slow and bumpy as the economy moderates.

- Peter Lazaroff, Investment Analyst