By Chris Turner
With 78% of companies reporting for Q4-12 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 February 15th, 2013. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See dshort's monthly valuation update for instructions on downloading the spreadsheet.
- The 10-year average of nominal TTM earnings is 61.26 at the end of 2012, rising to 66.98 by the end of 2013, based on "as reported" earnings forecasts.
- The average nominal cyclical P/E10 is currently 18.16.
- The S&P 500 historic prices used in the calculations are monthly averages of daily closes.
- Standard & Poor's estimates of TTM earnings for Q4 2012 through Q4 2013 are $87.96,$89.30, $93.08, $97.91 and $100.71 (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 2013 year-end earnings of $100.71 and an average nominal P/E of 18.16, we would see the S&P 500 at 1829. At this level, the nominal P/E10 would be 28.70, and the index would be about 50% 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 18.16 and the 10-year average earnings of 87.96 for December 2012. 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 1613 in the S&P 500 by the end of February, 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.