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Only Yesterday

On May 30, the S&P 500 finally recovered all ground lost in the 2000-02 bear market. How do current conditions compare to the previous record close seven years ago?

From Standard & Poor's Equity ResearchIt seems like only yesterday the S&P 500 posted its previous closing high of 1527.46. That milestone, achieved on March 24, 2000, represented a 4.0% year-to-date advance in 2000, and a 57% jump from the September swoon of 1998, occasioned by the Long Term Capital Management implosion and the Russian debt crisis. But when I look back at pre-9/11 prices, I can't help but think, "Boy that was a long time ago."

In March, 2000, Bill Clinton was still President. Al Gore was less green than hopeful. George W. Bush was Governor of Texas, and Vladimir Putin was waiting to be sworn in as President of Russia. More specifically, headline CPI was up 3.7% on a year-over-year basis, Fed Funds were at 5.75%, the 10-year T-note yielded 6.21%, gold traded around $275 an ounce, and oil hovered a shade above $30 a barrel.

From March 2000 through October 2002, the S&P 500 suffered through a 49% decline, followed by a 31% plunge in S&P 500 operating earnings. By October 9, 2002, however, the market had enough and was ready to recover. Since then, it's been a long four-and-a-half years, but the S&P 500 finally eclipsed its old high on March 24, 2000. And it seems a good time to take a look back and assess the changes.

From March 24, 2000 through May 30, 2007, while the S&P 500 just returned to breakeven, the S&P MidCap 400 advanced 85% (excluding dividends), and the S&P SmallCap 600 increased 101%. Eight of the 10 sectors in the S&P 500 recorded increases from as little as 11% for consumer discretionary and as much as 154% for energy. Only tech and telecom are still in the hole by 44% or more.

Representation within the "500" changed dramatically, with the market capitalization-weighted exposure for information technology and telecom now half of what it was at the previous peak; consumer discretionary's exposure is also slightly lower. Energy and utilities saw a doubling in representation, financials nearly did, while consumer staples, health care, and industrials increased their influence.

The most surprising change in the past seven years, in my opinion, has been the advance in earnings per share, which has outpaced price increases in all three benchmarks and in seven of the 10 sectors. All but one sector saw at least a double-digit increase in earnings per share during this period.

Equally of interest has been the resulting change in valuations. The P/E for the S&P 500 on trailing 12-month operating results contracted during these past seven years to around 17 currently from nearly 28 at the end of the first quarter of 2000. This happened despite the accounting for options beginning in 2006, which, had it not occurred, would have resulted in an even greater P/E contraction. The mid- and small-cap benchmarks also saw reductions, but by lesser amounts.

What's more, eight of the 10 sectors in the S&P 500 saw P/E tightening of 10% or more, with consumer staples and utilities being the only ones to experience a P/E expansion. (Amazingly, investors in 2000 were still willing to pile into tech stocks, though they sported a trailing P/E of more than 66).

This subsequent P/E contraction for a majority of sectors indicates to me that investors have been less willing to repeat the mistakes of the past by pushing share prices well ahead of fundamentals.

As a result of strong M&A activity, share buybacks, lower inflation data, and a first quarter earnings season that investors believed to be better than expected, the S&P 500 advanced more than 7% in price during this second quarter. The trailing operating P/E on the S&P 500 is now at 17 times earnings, a 12% discount to the average P/E of 19.4 since S&P started capturing operating earnings data in 1988. Should investors continue to feel comfortable with this multiple through the end of the year, a P/E matrix would indicate the S&P 500 could be trading near 1600 if earnings for the "500" climb the 7.3% S&P equity analysts currently expect.

Of course, it won't likely be smooth sailing from now until the end of December. S&P's Investment Policy Committee continues to have an end-of-year target price of 1510 for the S&P 500. There are several factors that might upend the market's remarkable near-term momentum. Those include the projected deceleration of S&P 500 earnings per share, and the potential negative impact elevated gasoline prices may have on consumer spending.

We'll just have to wait and see.

Stovall is chief investment strategist for Standard Poor's Equity Research Services.

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