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STOCK MARKET DOWNSIDE RISK VS. UPSIDE POTENTIAL

Summary:
Despite all the recent stock market volatility the actual S&P 500 PE on trailing operating earnings is almost exactly where my model says it should be. The biggest problem is that the market PE  is about 19 and bond yields are under 2%.  The quick and dirty rule of thumb is that a 100 basis point change in yields should generate a 100 basis point change in the S&P 500 PE.    With bond yields already under 2% the upside potential for the market PE is under 200 basis points — driving the PE to the upper limit of the fair value band. Consequently, further market increases are almost completely dependent on earnings growth. But currently, unit labor cost are rising faster than prices as measured by the non-farm business deflator and world economic growth

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Despite all the recent stock market volatility the actual S&P 500 PE on trailing operating earnings is almost exactly where my model says it should be.

STOCK MARKET DOWNSIDE RISK VS. UPSIDE POTENTIALThe biggest problem is that the market PE  is about 19 and bond yields are under 2%.  The quick and dirty rule of thumb is that a 100 basis point change in yields should generate a 100 basis point change in the S&P 500 PE.    With bond yields already under 2% the upside potential for the market PE is under 200 basis points — driving the PE to the upper limit of the fair value band.

STOCK MARKET DOWNSIDE RISK VS. UPSIDE POTENTIALConsequently, further market increases are almost completely dependent on earnings growth. But currently, unit labor cost are rising faster than prices as measured by the non-farm business deflator and world economic growth remains very weak.  While this spread is a powerful determinate of earnings growth you have to be careful with it as the most recent observations are subject to significant revisions.

Given these conditions the stock market downside risks clearly looks larger than the upside potential.

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