With the S&P 500 down 12.6% from its peak, its worth looking at what the numbers have to say. Markets tend to peak when valuations are expensive, and animal spirits high. They tend to bottom when valuations are cheap, and animal spirits low. However, markets tend to become cheap only when recession risk is perceived as high. And I don’t see recession risk as being high. I am happy to up my allocation to equity when animal spirits are very low, and have been low long enough to drive valuations down from expensive to neutral.  

The S&P trades at 17.5X trailing 12 month operating earnings. That compares with a long-term average of 17 (median 16.3 times). This suggests that the market is at neutral valuations at 1,814, which is not miles away from present levels: a decline of 2.7% would take markets to neutral zone. Relative to 2016 earnings expectations, the market is already at neutral valuation levels. And relative to 2017 earnings expectations the market is at neutral levels, tending towards cheap. Thus, as of now, in my view, valuation remains at neutral levels.

Cuts to earnings estimates have taken 2016 earnings expectations into neutral zone – but I suspect the risk of further cuts remains elevated. Forward year expectations are also neutral zone: but again the odds of a cut to forward earnings estimates elevated.  2015 was hard on earnings, with S&P 500 operating earnings declining from $113 in 2014 to an expected $105 in 2015. Earnings expectations for 2016 and 2017 are at $120 and $140 respectively. I would not be surprised to see 2016 expectations rise: after all 5.3% annualized earnings growth from 2014 ought to take earnings for 2016 to $125. But 2017 is likely to be cut – the long-term historic average earnings growth of 5.3% would take 2017 earnings to $132, using 2014 earnings of $113 as the base year. Overall, in my view, the risk to present earnings estimates is in neutral zone.

A market devoid of exuberance would take the market to 2.1K in a year if 2016 delivers near $120 in earnings. That delivers a 13.5% return. And there is much upside to that: we could see earnings estimates rise, and should they rise, the market shall not remain devoid of exuberance. A level of 2.28K in 12 months would not surprise me.