Neither Cheap nor Dear

S&P thinks the market's current valuation is consistent with its projection of modest gains for the year

By Joseph Lisanti

Standard & Poor's Investment Policy Committee expects the S&P 500 index to end the year at 1270, or about 4.8% higher than its 2004 close. We also project that S&P 500 operating earnings will rise 12% this year. Some people see a contradiction in these numbers.

After all, stock market performance is supposed to be closely linked to earnings. Yet, this year, we estimate operating earnings will rise 2.4 times more than the "500." But that's better than last year, when S&P 500 operating earnings growth was 2.7 times the rise in the value of the index.

In truth, such divergence is not out of the ordinary. In the past decade, earnings growth and price appreciation were close only once. And sometimes share prices advance more rapidly than earnings. From 1995 through 1998, operating earnings showed a gain of only 39%, while the S&P 500 index rose 168%.

That the market currently is lagging behind earnings growth can be interpreted as part of a continuing adjustment to the bubble of the late 1990s and its aftermath. It is the reason that the S&P 500's price-to-earnings multiple on trailing operating profits has declined from 29.6 in 2001 to about 17 now.

Although a p-e of 17 on trailing earnings doesn't sound particularly cheap to us, neither does it appear very rich. That is why we continue to expect modest gains in stocks for the year.

Yields on money market funds are climbing as the Federal Reserve continues to slowly increase short-term rates. We expect that, at some point, the 10-year Treasury note will also sport a higher yield. That will mean losses for holders of existing bonds, which is why we continue to recommend holding relatively short maturities in the bond portion of our asset allocation.

One day, bonds and money market funds may become more attractive alternatives for investors. Until then, we think U.S. stocks should be 50% of your holdings.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook

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