S&P 500 Should Soon Surpass 1,500 if History Is a Guide

While small caps have momentum, large-cap stocks have most favorable valuations, S&P Capital IQ says

Nearly seven decades of history foretell an immediate stock price surge following significant market declines, thus signaling a rally in the waning months of the year. So says S&P Capital IQ’s new global equity research report, released Monday.

The report says the current bounce follows a nearly 10% pullback that started on April 2.

Sam Stovall of S&P Capital IQ“Since 1945, whenever the S&P 500 has recovered fully from a pullback (decline of 5%-10%), it recorded an additional average price advance of 4.6% (median) and 7.8% (mean) in approximately three months,” writes S&P’s chief investment strategist, Sam Stovall (left).

“Therefore, if history should repeat itself, and there’s no guarantee it will, the S&P 500 could advance to between 1,500 and 1,550 before year-end.”

A large chunk of the gain in stock prices occurred Thursday, when the Standard & Poor's 500-stock index rose 2% after European Central Bank (ECB) President Mario Draghi pledged to loosen monetary policy to support Europe’s weak economy.

Stovall writes that markets have shifted to riskier small-cap stocks since the early June market bottom in anticipation of central bank easing. While the S&P 500 has increased more than 12.5% since then, the S&P SmallCap 600 index has risen 14.2%, with energy and telecom sector components registering gains of more than 20%.

While small caps have price momentum on their side, S&P Capital IQ projects that large-caps will outpace small-caps for the remainder of the year based on valuation advantages.

Stovall writes that the S&P 500 is trading at a price to earnings ratio (on 2012 earnings per share) of 14. Since the median P/E for the large-cap index has been 18.2 (since 1995), that gives the large-cap index the possibility of a 30% expansion to match historic valuations.

In contrast, the S&P SmallCap 600’s current 19.9 P/E multiple leaves room for just a 7.5% rise before hitting that index’s median P/E of 21.4.

Stovall adds that fully nine of the index’s 10 sectors currently trade at valuation premiums to their large-cap peers. Small-cap telecom services stocks are the only group that trade at a discount to their S&P 500 counterparts.

S&P Capital IQ concludes: “Based on the differential between the 2012E P/E and the 17-year median P/E for large- and small-cap stocks, it appears to us that the large-cap index has the greater upside potential based on relative valuations.”

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