Historical Data Disproves 'Trough P/E Multiple on Trough Earnings' Myth

Doug Kass, a hedge fund manager dedicated to short selling and frequent guest on CNBC, made a call on the air Monday that the S&P 500 could make its lows for the year this week. A bold call indeed, given that Doug is a short seller and has been correctly bearish on the economy’s prospects for a long time. His reasoning is mostly based on extreme pessimism (not unlike in November when we made a short-term low) and low valuations.

Other commentators debate the valuation point. CNBC’s own Bob Pisani made the case that assigning a 7 or 8 P/E ratio (a typical number at bear market bottoms) to this year’s depressed earnings level forecast (currently around $50 for the S&P 500) is reasonable. Pisani concluded that unless you think that earnings in 2009 will be substantially above $50 (which is very unlikely), the market is not cheap because 7 or 8 times $50 is 350-400 on the S&P 500 index, versus today’s sub-700 level.

When Kass was on the air on Monday he rightly suggested that putting a trough P/E on trough earnings is not appropriate, but market commentators continue to insist that is where the market needs to go before a cyclical bottom can be put in.

I have argued against this logic on this blog before (sorry to keep harping on it), but I decided to dig up some evidence on this topic so perhaps we hear less of it in the future. Below you will find the earnings of the S&P 500 relative to the level of the index from 1970 through 1985, a time period that encompasses both the early 1970s recession and the early 1980s recession, both of which are similar in depth to what most believe will be our fate this time around.

From this data you can clearly see why everyone is using a trough P/E ratio of between 7 and 8 times earnings (the bear markets bottomed at a 7 P/E in 1974 and at 8 in 1981). The year of both market bottoms is in boldface to show these levels.

The key here is to look at the level of S&P 500 earnings during both 1974 and 1981. Although the stock market traded at the trough P/E ratios during those years, earnings were at record highs both times! The 1974 level of earnings ($9.35) had never been reached before. The same goes for 1981 earnings ($15.18). Therefore, the idea that we take trough earnings and apply trough P/E multiples is simply unfounded if we look at the very data people have supposedly been using.

Not surprisingly, I am far from the first person to point this out. John Hussman, former professor of economics and international finance at the University of Michigan, actually has created a more relevant P/E ratio called “price to peak earnings” which suggests that trough P/E ratios on previous peak levels of earnings are far more reliable bear market valuation tools.

Where would this type of P/E ratio peg the bottom of the current bear market? Well, S&P 500 earnings peaked at $87.72 back in 2006. Multiply that figure by 7.3 and 8.1 and you get a range for the bear market trough of between 640 and 710 on the S&P 500 index. Interestingly, especially given comments from Doug Kass predicting a possible yearly low this week, the index is in the 680s currently, which is right in the middle of that projected range.

Hopefully actual data is enough to debunk seemingly popular myths about bear market low valuations for the stock market. While this evidence does not make it impossible for the S&P 500 to dip to 400-500, it would make such a move unprecedented in terms of the last four decades of market history, during which we have seen two recessions that are proving to be very similar to this one.

Comments

[pelican:]

Actually, I like the author's point. Sure, no two recessions are alike. Even the 1973-4 recession differed from the 1981-2 recession; yet, their trough multiples were pretty close! The media has latched onto this idea of using a trough multiple on trough earnings and so there is this expectation among many that we will see another 50% on the downside. So I guess companies like PG, JNJ, or PEP, which currently trade around 11-12x forward earnings will drop to mid to high single digit multiples. Seems unlikely in my view. The current recession is bad, no question. But it's not all bad compared to 1973-4, which most agree is a closer parallel than 1981-2. Interest rates and inflation are lower, for example. This time around I would also add that earnings projections for the market are being depressed by writeoffs in the financial industry. I won't say we are at the bottom because the 1973-4 bear market lasted around 20 months I believe and we are into our 17th month. Nonetheless, I expect a bottom this year (actually July is my forecast). Incidentally, during the Great Depression stocks took 35 months to bottom. The economy was in much worse shape though and stock p/es were richer back then (average p/e was 32 at its peak).

Mar 08 06:54 AM

[praha1:]

No the analysis is completely incorrect! It should be painfully obvious to any fool by this point that what we just went through in 2008 was a 1929 event and what we're currently going through is a 1930 event. The history that should be studied is the history of depressions - not recessions. Stop kidding yourself or be prepared to lose all your money. No one should be in stocks. History clearly states you're in the midst of downleg 2 which will bring the Dow down to between 5 and 6000. This will be followed by downleg 3 (Fall 2009) which will last about 14 months and bring Dow down to 1500 - 3000. You might want to consider buying at that point but even then you'll need a very strong stomach.

Mar 08 08:17 AM

[Free2Speak:]

I am constantly amused at comparisons with the "Great Depression". The press, along with the administration, have been hyping this recession to no end. When you normalize the data for population growth, this recession has been no worse than the last two. Based on the volume of layoff news, the employment issue has peaked. Moreover, couple the extraordinarily high level of shorts and the fact that there is far more cash on the sidelines this time around than during previous recessions, we are poised for a strong rally. When will it come? Who knows! But, when it does, the shorts will be running for the hills and the sideline money will pour back in to take advantage of the run. We may be in for more negatives for a few months. But, this market is grossly oversold and the money is there to drive it back to higher levels.

Mar 08 08:28 AM

[Lok Sang Ho:]

I agree completely people make wrong parallels to the Great Depression. Then banks were failing by hundreds every year. How many banks have failed so far?

Mar 08 08:57 AM

[logicalthought:]

Three points:

1) You're putting a multiple on "peak earnings" that were grossly inflated by non-existent financial services "earnings". Absent some sort of hyperinflation (and that's a completely different debate topic), those earnings may not be seen again for at least five years, and maybe longer. No one will put a multiple on THAT number.

2) What makes you think that $50 will be the earnings trough? What if it's $30? Do you think investors will be willing to "pay up" for stocks now, when 2010 earnings could be even WORSE than 2009?

3) The rate of corporate defaults can only accelerate over the next 12 months, thereby wiping out more and more equity holders, and thus further driving down the indices. (Defaults tend to lag the downturn in the economy, as debtholders will try to work with debtors for as long as possible before finally throwing in the towel.)

Mar 08 08:58 AM

[Lok Sang Ho:]

I would like to supplement my remark with this link:

www.livinghistoryfarm....

Mar 08 09:00 AM

[Lok Sang Ho:]

I would like to supplement my remark with this link:

www.livinghistoryfarm....

Mar 08 09:00 AM

[Eric Fox:]

Has anyone done the same trough analysis using price to sales? Given the volatility of earnings and questions on the earnings quality, might it be more worthwhile to use price to sales?

Mar 08 02:17 PM

[Prudent Man...:]

Kass may be right but he was wrong for 2,000 points. Does this mean we should wait for 2,000 more points? I don't know and I have a lot more experience than Kass. One must understand that Kass likes Obama's Socialism.

As for anyone on CNBC having an investment opinion, not one of their talking heads, except for the guys in Chicago, ever managed other people's money. They have everything in GE.

We always know the "P", it's the "E" that gets us every time. Yes, it was 7 during the seventies when Wyoming bailed out New York City, where all those "smart guys" live. What was the P/E of INTC and MSFT in 1999. They certainly have grown since then.

Some say the U.S see better days ahead. I say the country was much more relaxed and happy in the fifties. If materialism is the measure of your happiness that may too be in the past.

Mar 08 02:41 PM

[prudentinve...:]

I agree with your article, but with one important caveat.

If this was a "business as usual" recession, the market should be bottoming at close to current levels. However, the current re-formatting of our economy introduces a new environment with unpredictable and unintended consequences. Ditto for the global situation. Uncertainty rules the day for now.

Mar 08 03:29 PM

[bartpr:]

if one must look forward, how sould the trillion plus stimulus be factored into this equation? if it is not in the analysis or meaningless, everything else is flawed.

another point. bank earnings are a big part of the spy.
with most banks in the toilet, how can one come near to any analysis of the remainder of the components of the spy.

i like the trailing 10 year multiple of earnings analysis. the chart of the current and the 10 year are
tottaly different. on the 10 year we are near the
pe multiple of the 1982 bottom.

Mar 08 05:50 PM

[stocker:]

The failure of woo hoo WAMU had more assets on an inflation adjusted basis than every single bank that failed during the great depression. Banks were tiny community companies back them. Now the top 5 banks hold more than 50% of the banking assets in the country. The biggest of them Citi is already a failed enterprise in my view.

On Mar 08 08:57 AM Lok Sang Ho wrote:

> I agree completely people make wrong parallels to the Great Depression.
> Then banks were failing by hundreds every year. How many banks have
> failed so far?

Mar 08 06:42 PM

[Larrysyr:]

I appreciate the article and comments.

I've been interested in the P/E question recently, and this analysis adds some depth.

P/E gives a snapshot of reasonableness. The argument that we are in the bottom range certainly could be correct. It also could be correct that we're in for another 30% down. Neither of these scenarios seem far-fetched. (We could also get a sharp rally up about 30%, but I think that would be short-lived, unless the economic news flattens out.)

The average P/E ratio since the 30s is about 15. Presumably, higher ratios indicate an expectation of rising earnings, while lower ratios indicate declining earnings.

Right now, the market is between 13 and 14, based on 2008 earnings. So, there's a slight decline in earnings already priced in.

I'm not in a predicting mood, but I do think there are some good bargains available. I expect any company that survives this recession will do very nicely in the next 10 years or so. I'm looking for low debt, generous cash cushions, honest management, and boring, reliable business models I can understand.

Mar 08 07:14 PM

[BarryD:]

You make the statement...."While this evidence does not make it impossible for the S&P 500 to dip to 400-500, it would make such a move unprecedented in terms of the last four decades of market history, during which we have seen two recessions that are proving to be very similar to this one."

This recession, and possibly depression, is quite unlike anything seen post 1932 or 1937. Comparing it to the 70's is totally unrealistic.

The primary difference is that this economic cycle was built on leverage and we need to deleverage. Combine that with falling home prices and a tapped out consumer, it is very unlike the 70's. That has not happened since the 30's.

Mar 08 09:24 PM

[praha1:]

so what will it take to turn your amusement into hysteria - when the DOW is down 60% from its peak - probably in a week or two? Or perhaps when it's down 70 or 80% from its peak (likely this Fall). Will you be amused then? History clearly states that's where it's going.

Oh and BTW, it also states that you'll eventually blame it all on the Jews! (the historical scapegoat) rather than on youself for making bad investment decisions.


On Mar 08 08:28 AM Free2Speak wrote:

> I am constantly amused at comparisons with the "Great Depression".
> The press, along with the administration, have been hyping this recession
> to no end. When you normalize the data for population growth, this
> recession has been no worse than the last two. Based on the volume
> of layoff news, the employment issue has peaked. Moreover, couple
> the extraordinarily high level of shorts and the fact that there
> is far more cash on the sidelines this time around than during previous
> recessions, we are poised for a strong rally. When will it come?
> Who knows! But, when it does, the shorts will be running for the
> hills and the sideline money will pour back in to take advantage
> of the run. We may be in for more negatives for a few months. But,
> this market is grossly oversold and the money is there to drive it
> back to higher levels.

Mar 09 12:36 AM

[Fred Voetsch:]

WOW!

The ability of people to pick out data they need to confirm what they wish to believe never ceases to amaze me.

Ask yourself why this person picked out data from the time period he used?

Ask yourself why he didn't expose you to the S&P data at www2.standardandpoors.... and www2.standardandpoors.... which tells us that reported earnings are historically relevant earnings - not operating earnings - and that the current P/E ratio for the S&P 500 is 40; 14 using operating earnings...and falling so fast that Q4 was negative for both reported AND operating earnings.

What this person does not understand is that deflationary eras like this seriously damage the economy as they wring out all the leverage put into it over the past several decades. He is ignoring the 1930's for a reason: they do not fit in with his hopes and dreams.

In the 1930's the DJIA saw three years of negative earnings and it also saw that index drop by nearly 90%. We have now achieved negative earnings and are only down a bit over 50%. Consider how fast we dropped from 9,000 to 6,500 on the Dow. An additional drop of 2,500 points brings us to 4,000 and that is why the latter stages of a bear market are the most brutal; the point drop is the same but the percentages are higher. Go back and look at 1931 and 1932 and ask yourself if you believe it can't and won't happen again, and please, base it on all the data available to you, not just the sliver that Chad presented to you.

Mar 09 03:48 PM

[Fred Voetsch:]

On Mar 08 07:14 PM Larrysyr wrote:
> The average P/E ratio since the 30s is about 15. Presumably, higher
> ratios indicate an expectation of rising earnings, while lower ratios
> indicate declining earnings.
>
> Right now, the market is between 13 and 14, based on 2008 earnings.
> So, there's a slight decline in earnings already priced in.

No. The P/E right now, as of today, based on all reported earnings up to Q4 of 2008 is 40. That is using reported earnings, which is all you should be using to compare today's data with that of the 1930's, 40's, 50's, etc. since operating earnings weren't around back then.

Please read these explanations from Standard and Poors about how to apply operating earnings and reported earnings. www2.standardandpoors....

S&P states:

"As Reported Earnings: Earnings including all charges except for discontinued operations and extraordinary items, as defined by GAAP. This is the broadest measure of corporate performance of the three considered here. It is also the traditional measure with a long
history. It has been used for the S&P 500 and for company analyses for decades."

"Operating Earnings: This measure focuses on the earnings from a company’s operations. It is usually defined by As Reported Earnings with certain charges reversed to exclude certain corporate or onetime expenses. The major drawback is the lack of a generally accepted definition. The use of Operating Earnings seems to come from internal management controls used when a business unit manager is not responsible for managing corporate-level costs."

Now view the S&P earnings report at
www2.standardandpoors....

Using operating earnings the current P/E is a bit over 14 and that is only slightly below the historical average of 15/16. But do you really want to use operating earnings when they provide no historical comparison?

Now it's up to YOU to determine when you think earnings will start going up once again. But until they do the stock market will likely go lower and lower and 300 isn't out of the question at all, given current conditions and historic precedence.

Mar 09 04:04 PM

[Fred Voetsch:]

On Mar 08 08:57 AM Lok Sang Ho wrote:

> I agree completely people make wrong parallels to the Great Depression.
> Then banks were failing by hundreds every year. How many banks have
> failed so far?


Not nearly as many but the BIG difference is the SIZE of the banks failing. WAMU was huge and it failed. Now imagine how many would have failed if we hadn't bailed out the big ones like CITI and BofA that are tetering on the brink of collapse?

Do you know that the FDIC sent out notices to the banks that it may be insolvent later this year? Please take your blinders off as they are only keeping you from protecting yourself.

Mar 09 04:10 PM

[nerraw:]

Hi Fred,

Well said. What sould an investor do in these times?

Best Regards,

Jul 06 12:30 PM

[nerraw:]

Fred,

Well Said.

Assuming your analysis is accurate (and I think that it is) what is an investor to do.?

Best,




On Mar 09 04:10 PM Fred Voetsch wrote:

> On Mar 08 08:57 AM Lok Sang Ho wrote:

Jul 06 12:33 PM