What Is the New S&P Normal?

A thought experiment I like to do is mull what S&P 500 earnings would have been today if we hadn’t had a decade or more of cheap credit. Earnings have grown, on average, 9% a year for years in the U.S., but that has been goosed to an unknown degree by credit.

What would the world look like otherwise? Well, one way to back into an (admittedly simplistic) answer is pick a date in the past, and then project forward from there at some more reasonable economy-wide earnings growth rate.

Fair enough. But what would that be? Well, corporate earnings can’t grow forever faster than GDP or their share of GDP rapidly becomes crazy-large, like all of GDP in a few decades from the current starting point of 7% of GDP. The upshot: The trend growth in U.S. GDP is a reasonable floor, so let’s call it 3.4%. With that in mind, somewhere between 3.4% and 9% earnings growth is a reasonable place to start in projecting forward to what an ex-leverage S&P 500 earnings number might look like today.

Using the preceding, and having picked 1987 as the starting date for the exercise (which isn’t completely ad hoc), here is what I end up with under various growth and earnings multiple scenarios S&P 500. The upper table is 1987 S&P 500 earnings projected forward to 2008-2010 under various conditions; the lower table is an array of resulting S&P 500 targets.

In short, depending on when you start, what ex-leverage growth rate you pick, and what trough multiple you apply, you can get to S&P 500 targets in 2009 from 268 (!) to 1135 (!!). To narrow things down, say you pick something mid-range for ex-leverage growth, and apply a 12x earnings multiple on the S&P, which seems fairly conservative, you get to a 612-754 target.

Of course, the preceding assumes at least two other important things. First, it assumes that markets don’t overshoot, which they almost always do. Second, it assumes that global trade stays close enough to trend that such comparisons are meaningful, an assumption that I think highly unlikely given the rapidity which worldwide trade is now tumbling.

Is this scientific? Of course not. It is, however, a way for you to at least capture the relevant earnings / growth / multiple dimensions in a way that shows you some possible implications for the overall market.

Comments

[mcadoo3312:]

I like how you came to your conclusions, but because the market is forward looking, does it really matter that the previous gains were based on credit? Credit is not going away completely, it is just diminishing. Companies with solid balance sheets and products in demand should still fare well. Those that have less desirable products (ahem, crocs) will get crushed. A company like Cisco immediately comes to mind. They have an incredible amount of cash, and even though financials are a large part of their business, their products going forward are still efficient and make other organizations better. We know how much they have been crushed, so does placing an artificial P/E on it make any difference in the ultimate decision to own the company? Unless you need to do so to make quell your cognitive dissonance, I would say no.

2008 Dec 12 01:16 PM

[DonSuper:]

you forgot to add inflation, duh!!!

2008 Dec 12 07:27 PM

[George Kesa...:]

I totally disagree. Earnings growth over the past several years is more a product of globalization than cheap credit.

The concept of platform company is the main reason.

Western companies have outsourced their production, so all that remains is R&D and marketing.

They have become lean and mean (and remain so today) and that's why balance sheets (ex banks) are is so fine condition.

I think that once we get over this credit mess, earnings will once again rise to record levels and maybe even higher.

One can argue about the western consumer, buts that's another story.

2008 Dec 13 06:17 AM

[Dusty:]

Interesting chart. Use those values, add a factor for inflation, maybe SPX at 850 'is' at the mean? This is also about where it was in December 2002. I can only look back 10 years. It would be very interesting to look back to the 1970's or even better to 1950. Correct for inflation along the way, see where the median line adjusted for bubbles and (1987?) Technical Glitch Crashes fell?

2008 Dec 13 05:02 PM

[THofler:]

Your reference date is 1987?? So you are trying to deconvolve the entire Greenspan era?

The small but obvious problem is that the really cheap credit problem only arose from from the 1% Fed funds rate that started in 2003. Also, problematic credit occurs with a delay with respect to the Fed rate.

The larger problem with "undoing" the outsized gains of the S&P500 throughout all of the 1990s is that much of this stems from the real economic benefit of the large productivity enhancement related to the ubiquitous computerization of our economy. While we don't seem to be producing the large strides in efficiency right now, that doesn't mean that they didn't happen back then. Those previous efficiency gains are still with us.

2008 Dec 13 07:51 PM

[gordon:]

recession p/es were 5-7. Certainly, above 10 is overvalued ,especially when all forward earnings are a fraud. Companies can't borrow money or have cashflow to buy back shares. I maintain the massive share buybacks, i.e. $600 Billion by the top 6 banks in 2007, before they cratered and asked for bailouts, is the most ignored story in the media. Reducing share count is a scam, a conjob on America because they pillaged their cashflow needed to have on hand for times like now. They chose artificially propping "pps" instead of paying a living wage. Bush allowed the repatrioting of foreign profits to created jobs, and it was NOT supposed to be used for stock buybacks, like there was a buyback police! Not one job created, they paid 3.5% tax and used the rest for buybacks and acquisitions.

2008 Dec 13 08:21 PM