The stock market fundamentals are reasonably good. Valuations are helped by low interest rates.  The economic and earnings outlooks are decent but not great.  Risks are higher than normal but lower than a month ago. 

Valuation

Valuation is always a good starting point for assessing the stock market outlook.  Right now, valuations are reasonably good. 

The price/earnings multiple (P/E) on the S&P 500 index in aggregate for operating earnings is 17.0 through second quarter earnings. 

That is a slightly higher multiple than the market has carried for a couple of years, as the range has been near 16 to 17.

From a historical standpoint, this a bit high, but that is because inflation and interest rates are at historically low levels.  A (very) old rule of thumb is that the P/E should be 20 less the rate of inflation.  With inflation at about 2%, it can be argued that the current stock market valuation is a bit low.

Another way to assess stock values is to compare the earnings yield (E/P, the inverse of the P/E) to bond yields.  The current earnings yield is 5.88%.  The 10-year note yield is only 4.63%. 

It is often presumed that the yield on stocks based on the year-end earnings expectations should approximate the 10-year note yield.  Even with an assumption of no earnings growth next year, the yield on stocks is about 27% higher than on bonds.  With even modest earnings growth, stocks yield about 30% more than bonds, and on this basis can be viewed as very cheap.

Earnings

The P/E is only a starting point for valuation because the earnings outlook is also a critical factor in assessing the fundamentals.

Right now, the earnings outlook is mixed. 

Forecasts for third quarter operating earnings, which are due to start being reported this week, are for a 2% to 3% gain in earnings over the third quarter of 2006. 

This number has not come down much in recent weeks even with the clear earnings problems at financial firms, in part because the mortgage-backed problems are often being treated as one-time charges.  This reduces the "quality" of earnings and full as-reported earnings growth could be nearer to unchanged, but the reaction to recent announcements of charges by brokers and banks suggests that the market will look past these problems. 

Fourth quarter earnings expectations are for a robust 10% gain.  A large gain is likely due to an easier year-ago comparison in energy.  Forecasts are also for about 10% earnings growth in the first half of 2008. These gains could prove difficult to achieve, however, if economic growth remains sluggish.

Rightly or wrongly, though, the expectations that earnings growth will rebound to near double-digit growth starting in the fourth quarter of this year provide underlying support to stocks.  These expectations are only likely to come down significantly if expectations of a recession pick up. 

The Economy

The September employment data released Friday should go a long way to dispelling recession concerns.

The data indicate that current macroeconomic trends are sufficient to keep real GDP growth near 2%.  The nonfarm payroll gain of 110,000 is equivalent to about 1% annual growth.  Wages are rising at a 4% annual rate.  That keeps consumer spending power rising at a 5% rate, which is about 3% in real terms. 

Housing remains a significant drag on the economy, but so long as consumer spending and business investment continue to rise, recession will be avoided.  That is what has happened the past two years, and it is our expectation it will continue in the quarters ahead.

There is still a risk that the liquidity problems on Wall Street lead to a broader credit crunch, but that risk is fading fast as time heals the problems at financial firms.  Overall bank credit continues to rise.  There is also a risk that the housing market blows up, but it should stabilize some (at low levels) with the recent rate cuts.  A major wealth effect on consumer spending from lower home prices has not been seen in the nearly two years since the housing troubles started, and we don't expect it now.

Economic growth is slogging along just as it has for two years now.

Inflation and Interest Rates

This is the best news for the stock market.  The year-over-year increase in the core personal consumption expenditure (PCE) deflator has dropped to just 1.8%.  This is not a fluke.  The recent monthly changes have been low due to soft economic demand.

The year-over-year increase in the total PCE deflator is also up just 1.8% over the past year.  Food and energy prices have not been a major problem, although some modest pressures are likely in the immediate months ahead.

The good news is also reflected in the CPI data. The year-over-year increase in the core CPI is just 2.1% and for total CPI it is 2.0%.

Core inflation is likely to stay near the 2% level for at least the next six months due to the lagged impact of the recent sluggish economy.  The pressures from commodity prices and a weak dollar will have only a modest impact.

The low inflation rates were a key factor that allowed the Fed to lower rates in September.  The 10-year note yield may back up some from current levels, but with inflation so low, it should stay below 5%.  The Fed isn't about to raise rates any time soon, so the interest rate outlook remains decidedly supportive to the stock market.

What it All Means

The S&P 500 index is at an all-time high.  This is a bit surprising given the heightened risk in recent months due to the liquidity problems on Wall Street.

It reflects a strong long-term optimism that has merit, however. 

Current valuations are very reasonable so long as earnings growth continues at even a decent pace.  That will happen so long as the economy does not enter recession. 

The employment release Friday dispelled a lot of fears that current trends indicated the economy was entering recession right now.  There is always a risk that the housing crisis or a credit crunch develops to cause a recession, but there is no evidence that is happening a full two years after the housing downturn started. 

The good inflation conditions are a bullish factor for stocks.  Inflation rates have been declining the past year and the outlook is good.  Interest rates may fluctuate a bit over the coming year but from a historical perspective will be fairly stable at low rates.  The Fed may even cut rates again.

In aggregate, the fundamentals present a good argument for staying with long-term stock investments.  The outlook is not flat-out bullish as valuations are not a screaming buy, the economy is not at a low point and about to accelerate, and interest rates are not about to drop significantly. 

This is a time from a historical perspective when stocks are simply reasonably well valued and the earnings and interest rate outlooks are decent. 

Our near-term and long-term views are both moderately bullish.