Here are fundamental valuation arguments for the S&P 500 reaching levels ranging from about 500 to about 1,500 by year-end 2010.
2009 Year-End Valuation on Trailing Operating Earnings:
Street Opinion: Barron’s Online April 2nd reported the Reuter’s “street” estimate of 2009 S&P 500 “operating earnings” (not including non-operating expenses, such as asset write-downs, plant closures, layoff costs and other “non-recurring” items) at $59.18. Those analysts who would put a 10 to 20 multiple on trailing operating earnings as a “normal” range would see a 2009 ending index level of 592 to 1184 (mid-point 796).
Fed Model: The formerly popular “Fed Model” that justified a P/E equal to the reciprocal of the 10-year Treasury rate, doesn’t make a lot of sense in this period of risk aversion-driven low interest rates. If someone were nutty enough to use that model and the street operating earnings estimates for 2009, they would see a trailing P/E of 34 as reasonable, which would predict an index price level of about 2012. That’s more than 25% higher than the highest value achieved in 2007 before the current troubles began, so we’ll discount that as plumb crazy. Take those guys away and put them in padded cells so they don’t hurt themselves.
Standard & Poor’s Projections: S&P projects 2009 index operating earnings at $49.02 on a top-down basis, and $62.36 on a bottom-up basis. A trailing P/E of 10 to 20 on those numbers would put the index at 490 to 1247 (mid-point 868) by year-end.
2009 Year-End Valuation on 2010 Forward Operating Earnings:
Street 2010 Estimates: Barron’s reports the Reuter’s 2010 street estimate of operating earnings at $75.32. A 10 to 20 forward multiple on that would put the S&P 500 index at 753 to 1506 (mid-point 1129) by year-end 2009.
Individual 2010 Estimates: Deutsche Bank projects 2010 operating earnings at $61.70. JP Morgan sees $65, and Standard and Poor’s sees $48.44. Using the 10 to 20 forward multiple approach, their numbers would produce:
- DB: 617 to 1234 (mid-point 935)
- JPM: 650 to 1300 (mid-point 975)
- S&P: 484 to 968 (mid-point 726).
2009 Year-End Valuation on Trailing and Forward “As Reported” Earnings:
“As Reported” earnings include everything — nothing left out — all the bad, as well as all the good — but not what the rules may allow to pass through the balance sheet without going through the income statement.
Standard & Poor’s top-down projections of “as reported” earnings as of 03/25/09 are:
- 2009 – $34.74
- 2010 – $41.49.
While we don’t know what the historical norms are for operating earnings over long periods (because the term is not well defined — sort of whatever you want to report and whatever you want to exclude); “as reported” earnings is well defined and there are long-term historical records of the trailing P/E on those earnings.
Over an 81 year period through 2007, and eliminating the 10% highest and 10% lowest multiples; the range of P/E’s is 10 to 20 and the median is 15 (see our study).
Using 10 to 20 times trailing multiples on S&P’s projected 2009 “as reported” earnings, we get a year-end 2009 index price range of 347 to 694 (mid-point 520).
Using 10 to 20 times forward multiples on S&P’s projected 2010 “as reported” earnings, we get a year-end 2009 index price range of 415 to 830 (mid-point 622).
If we bring the crazy Fed Model guy back out of his padded cell for a moment, and allow him to assume that interest rates will not rise from now through 2010, and let him work with forward “as reported” earnings at his lofty 34 times multiple, we see 2009 ending the year at 1411 (about 10% below the 2007 pre-crash high).
Historical Trailing “As Reported” Earnings and Index Price Levels:
You might want to make your own guesses through analogy to prior years. Here are the “as reported” earnings, ending index price levels, trailing P/E’s, and year-end 10-year Treasury interest rates for the past 10 years. No conclusion, just raw data for you to chew on.
- 2008: $14.97 / 903 / 60x / 2.25%
- 2007: $66.18 / 1468 / 22x / 4.04%
- 2006: $81.51 / 1418 / 17x / 4.71%
- 2005: $69.93 / 1248 / 18x / 4.36%
- 2004: $58.55 / 1212 / 21x / 3.94%
- 2003: $48.74 / 1112 / 23x / 3.77%
- 2002: $27.59 / 880 / 32x / 3.36%
- 2001: $24.69 / 1148 / 46x / 5.07%
- 2000: $50.00 / 1320 / 26x / 5.12%
- 1999: $48.17 / 1469 / 31x / 6.45%
Our closest recent chart analogy to today might be 2002. Looking at the historical table above, they had a 32 trailing P/E multiple then. The banking and general economic context is worse now, however.
If we use the 32 multiple (oops! that sounds like the crazy Fed Model guy) on the $34.74 projected 2009 trailing “as reported” earnings, it might be possible to expect 1097 for the index by 12/31/09. Somehow that really doesn’t seem crazy at all, if all the government programs kick in and begin to work — just look out for the inflation and higher taxes that will be on the other side of the recovery.
Quantitative analysis can be comforting on the surface, but underneath earnings estimates and earnings multiples are highly subjective, widely dispersed, and not subject to strict definitions and methods.
In the end, quantitative and fundamental analysis is based in logic, but applied subjectively — and totally unable to predict shocks and/or arbitrary rule changes by government intervention. Remember that last week banks were failing due to mark-to-market losses, and this week they are doing much better, because new rules relax the mark-to-market requirement. No form of quantitative review could predict something like that.
Earnings estimates have been coming down, but they will probably overshoot, as they tend to do both up and down.
So in the end predicting price levels over short periods is just a bet — a better bet than at the casino, but still a bet.
The most important thing to do is to know what you want to own, why you want to own it, and then buy it when both its fundamentals and its price behavior are favorable to you.
After buying it, hold it regardless of its fundamentals, so long as its price behavior is favorable to you, using protective stops along the way.
When the price behavior becomes unfavorable (most likely when you are stopped out), put the security back on your shopping list and re-enter only when both the fundamentals and the price behavior become favorable once again.
If what you want to own is the S&P 500 index, the price behavior is still not fully favorable. The fundamentals surely don’t look good yet, and can only really look good when the banks, auto companies, and home values get straightened out.
The March index rise is the strongest since the 1930s, giving strong hopes to many observers and investors. However, the 1930s were also the beginning of several periods of multi-year index losses (see our study), so this rally does not necessarily portend a new upward world. We hope so, but we need more proof.
Clearly the current rally is powerful and appealing. You could say the price behavior is favorable, but the moving averages have not yet confirmed an upward direction. It could be the beginning of a bull, but we don’t know yet. Certainly, there are companies within the index that are surging, but the 500 in combination are still in an unclear price pattern.