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Risk-Reward Ratio Favorable

By Arnie Kaufman While the contraction in the manufacturing sector may not end until next year, S&P chief economist David Wyss believes that, overall, the worst of the economic slump is now behind us. He expects that tax rebates, Fed rate cuts, lower energy costs and a better balance between inventories and sales will gradually improve GDP.

Because the economy apparently just barely skirted a recession, the market's performance immediately before and after the nine postwar recessions may be relevant to the current period. In those nine instances, stocks started to rise from three to eight months before the economy turned up, with the average lead time five months. That would fit with a market bottom in early April of this year and an economic upturn getting under way this quarter. From the end of the nine postwar recessions to six months later, the S&P 500 averaged a gain of 14%.

The current P/E ratio of the S&P 500 index is high on a historical basis. But we at S&P feel this is justified, for several reasons. One is that the present is probably the low point of the earnings cycle, and depressed earnings raise P/Es. Another is that productivity is expected to remain elevated for some years. High productivity helps keep inflation and interest rates low and boosts corporate efficiency, leading to higher-than-normal stock valuations.

Also, a more generous multiple is warranted because the earnings growth potential of the S&P 500 has increased as the composition of the index has shifted over the years toward the technology and service sectors and away from manufacturing, reflecting the changing nature of the economy.

Finally, the economy these days is either better managed or less cyclical, as suggested by the extraordinary longevity of the current expansion. Reduced economic volatility should translate to higher P/Es for stocks.

We at S&P regard the market's risk-reward ratio looking out six to 12 months as favorable. Maintain an allocation of 70% equities, 25% bonds and 5% cash. Kaufman is editor of Standard & Poor's weekly investing newsletter, The Outlook

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