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By Chris Turner

With 91% of companies reporting for Q3-12 earnings season, here is the latest update of my ongoing "thought experiment" for forecasting the S&P 500 price based on earnings fundamentals.

The chart below is based on the latest trailing twelve-month earnings (TTM) data published on the Standard & Poor's website as of November 8th. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See dshort's monthly valuation update for instructions on downloading the spreadsheet.


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Here are the key assumptions in the calculations:

  • The 10-year average of nominal TTM earnings is 55.22 at the end of 2011, rising to 89.30 by the end of 2012, based on "as reported" earnings forecasts.
  • The average nominal cyclical P/E10 is currently 18.15.
  • The S&P 500 historic prices used in the calculations are monthly averages of daily closes.
  • Standard & Poor's estimates of TTM earnings for Q1 2012 through Q4 2012 are $88.54, $87.92, $87.79 and $89.30 (as of the latest spreadsheet).
  • The months between the quarterly earnings estimates are linear interpolations.

The blue line represents Standard & Poor's TTM forecast earnings by month multiplied by the historical nominal 10-year P/E ratio. At 2012 year-end earnings of $89.30 and an average nominal P/E of 18.15, we would see the S&P 500 at 1620. At this level, the nominal P/E10 would be 27.33, and the index would be about 47% above a hypothetical price multiple of the extrapolated 10-year earnings average.

The red line represents a hypothetical S&P 500 price that is a multiple of the average nominal P/E10 of 18.14 and the 10-year average earnings of 55.22 for December 2011. The monthly index price estimates thereafter are linear extrapolations based on average 10-year earnings growth.

The optimistic view (blue line) would put us around 1611 in the S&P 500 by the end of November, the assumptions being that the Standard & Poor's earnings forecasts are correct the nominal P/E10 ratio is the multiple we see.

The pessimistic view (red line) is a reversion to the historic earnings and nominal P/E10 multiple.

But history shows us that, regardless of your preferred earnings divisor (nominal or real, TTM or the 10-year average TTM), the P/E ratio has never hovered around the average. The market swings above and below its long-term average valuation in erratic arcs that can last for many years. For a long-term perspective on valuation extremes, see Four Market Valuation Indicators and the compelling research of Ed Easterling on the history of earnings per share.

Check back next month for a new progress report.


Note from dshort: For some interesting comparisons, here are Chris's charts from the last several months, based on the then current Standard & Poor's spreadsheets. )
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Source: Forecasting The Market: A Thought Experiment Revisited