The S&P 500 P/E Needs to Correct

A constant theme for any value investor is "price always meets value". They just do. It is the "when" that we cannot predict but we know eventually it does. For that reason we buy when the value is above the current price and sell when it reaches or exceeds it. Easy, right? Well, not really, it is the determination of what that value is that trips folks up and causes mistakes.

Thus is the dilemma of the current market. By any valuation it is way overvalued. The S&P 500 last Friday (5/15) after another quarter of reduced earnings (most are in now) sat at an stratospheric 122 times earnings. For those who are not sure what "normal" is, it is about 20 times earnings.

Here is the whole thing visually:
http://www.chartoftheday.com

So, that must mean the market is headed for a big fall, right? Well, there are two parts to the equation. The "P" or price and the "E", earnings. In order to get the ratio down to a normal level, the "P" must fall and the "E" must rise. Q1 earnings numbers were smacked by a -6% Q1 GDP. We know Q2 will be better and Q3 ought to show even more improvement (both may still be negative but less so). That means we can expect the "E" part of the equation to increase.

With S&P earnings as of last Friday at $7.21, it will not take much improvement for the PE ratio of the market to be brought down by even a modest earnings improvement. For reference, last year at this time the S&P had earnings of $62 and sat at 1400 vs. 888 today. For the market to sit where it is and have its PE fall to around a more "normal" 20 times earnings, they must increase 485% to $45.

Again, visually, this is what has happened to earnings:

http://www.chartoftheday.com

So, what happened to Q1? Companies wrote off billions in Q1 and used it as a "kitchen sink" quarter. We all expected it to be bad so they wrote down everything that had or might deteriorate in value. Q2 ought to show improvement if for no other reason, the massive Q1 write-downs ought to be just about over. Even if operating earnings stay flat, we will see overall earnings improve.

Again, visually (click to enlarge): This is the S&P operating earnings.

Notice Q4 was the worst operationally and improvement is expect through the year. This is what to watch going forward. As long as this continues upward, the rest will wash out in the end.

It is fairly safe to say that the decline in earnings is over, or nearly over and we ought to begin to see improvement. Note: this does not mean the overall economy improves immediately or dramatically, just that the decimation in earnings is done. Because of that, there is a very real scenario where the market just pauses and waits for earnings to catch up. Then, depending on the Q2 results as they come in, the next move in the market is defined. If they are as expected or better than expected, the market will feel justified at its current level. Should they begin to come in worse, the high levels it currently sits at will indeed appear irrational and we could see a decent sized sell off.

Please be aware that I am not predicting what the market is going to do over the next two months, none of us know that. What I do know is that the current PE of the market is unsustainable and has to come down to more normal levels. The only way for that to happen is a rapid rise in earnings and / or a fall from the current levels of the S&P.

It also means the risk to current levels is downward. If we do not get increasing earnings, the market has to fall to regain valuation balance. If we do get modestly increasing earnings, it could sit here while the earnings take down the valuation disparity. Either way, the markets upside is limited to down.

One then has to extrapolate from this that the market could continue its upward march if we get a large increase in earnings in Q2. That would justify the
recovery theme currently "en vogue" and reduce the market valuation in one step. All eyes then turn to continued improvement in Q3 for continued market appreciation.

In talking with one of my readers about the subject yesterday he said:

That is the way it happens. Markets that move ahead of earnings are always called “speculative”. It is a question that value players would answer that they buy on P/Assets or P/BV but sell on earnings expectation or P/E when the earnings come in.

A quote from Ian Cumming from the Leucadia (LUK) annual meeting I went to. “The science is in the “In”. The poetry is in the “Out”. The value buyer assesses the potential earnings power of the assets, but buys when there are no or at least very low earnings and the market not having the sense to do the same type of work is lost in the pricing and giving stocks away. But, when the earnings are at full potential and have recovered, the market believes that some new earnings trend has begun and priced the stock at “poetry levels”-“so beautiful” and it is this is where one should sell.

So what to do? Be careful. Something has to happen either way and two of the three scenarios have the market doing nothing to falling.

Comments

[prudentinve...:]

There are many who would argue that a "normal" P/E is closer to 12 than 20. Indeed, your first chart indicates an average around 12 for the sixty years ending ca 1995, before the "norm" climbed to the 20 you referenced.

I would suggest that a historic "normal" P/E of 12 resulted from the perception that stocks were risky, and so had to return an excess "risk premium". The more recent "normal" P/E of 20, was likley the result of stocks being viewed as risk-free in the post-1995 era of the "Greenspan put". As the perception of stocks being risky makes a comeback, I suspect we shall return to historical P/E norms closer to 12 than to 20.

May 24 09:14 AM

[kotika98:]

Cramer also used to say that you buy cyclicals when the PE is highest, and sell them when PE is lowest. Now that cycle has come around, and we are reminded that almost every company depends on the general economic health to make money. So, dont worry be happy - the earnings graph shows we will recover to S&P earnings of between 50 and 70 within a year or year and a half. I honestly dont know what the level of the index that justifies, but the market trades on next years earnings not on current quarter earnings. Keep that in mind when you look forward to Q2 results. In any case Q2 is traditionally a non-event, the three other quarters are always alot more important. Q1 gives the start to the year, Q3 is back to school quarter, and Q4 is christmas quarter. Thats on the consumer side, and on business spending side capital investment decisions are not made in Q2 either.

May 24 10:14 AM

[kotika98:]

Ok, and another thing... I am all for fundamental analysis, but over the years i am more and more aware that professionals value companies on EV/EBITDA. This past year this has become even more crucial as the EV/EBITDA measure emphasises strong balance sheets. For example PE ratios in some industries such as tanker and bulk shipping and yes, banking, were already very low going into 2008 --- all for a good reason! The market was correctly discounting their highly leveraged balance sheets.

May 24 10:45 AM

[Ergo:]

A lot of recent earnings are boosted by cost cutting and employee cutting, while revenue falls. IMO, there's still a few ripples to be felt. I've learned in everything else besides stocks to never pay too much when I buy something. Now there's a lot that can be written about whether or not a stock price is a good "value." But high PE ratios aren't what value investors look for. I agree with the author's analysis.

May 24 11:35 AM

[TheFounder:]

The likely scenario is S&P earnings stabilizing at $45-50 and P/E at 12-15. That means a trading range of 540-750.

For the optimists among us, take 15-20 and you get a range of 675-1000.

The next earning season will dissapoint and we shall see a correction down starting in June as warnings begin.

May 24 03:14 PM

[Short Bus:]

It would be interesting to see the same charts but using the
EV/EBITDA instead, to see how that changes the historic references.

May 24 05:10 PM

[cameroni:]

Thanks for that update Todd. It's an eye opener. The first chart is a real stunner too. Like most graphs these days, visually, it's "off the charts".

May 24 06:28 PM

[Prudent Man...:]

Evidently none of the above in the seventies when the DJIA sold between 7 and 9 times earnings. At that time we were entering the technology age and our economy showed real growth. Where is the growth coming tomorrow?

We are not even close to a bottom as toxic assets have not been liquidated, banks are delaying foreclosures in order to not have to pay fees, taxes, insurance, etc. so we don't even know the real estate hangover. Add to that the unemployment of auto dealers' employee and the effect of their empty lots on commercial real estate.

Do we have a clue as to what our economic problems, let along answers to them, yet for seeing a bottom and growth?

May 24 07:11 PM

[Fred Voetsch:]

This is all pretty simple.

Best scenario: We return to high growth and high P/E ratios like we have seen for the past 2-3 decades. S&P moves steadily up from here.

Worst case scenario: We are in a revaluation era in which the recent valuations of the past 2-3 decades will not only not be pertinent but will be adjusted for and we will see lower than normal (normal being 15) P/E ratios for a decade or two or three. The false wealth that was leveraged into the economy for decades will take decades to deflate out while China pushes up the price of commodities, further stressing our economy. S&P 500 falls to 200.

Somewhere in between: Normalized earnings of $30-$40 for the S&P 500 are the result of a slow growth recovery most often predicted and a normal P/E of 15 results in the S&P 500 valued in the the 450-600 range.

Before you comment please make sure you are dealing with the facts by going to S&P's own data at
www2.standardandpoors....

Also read the S&P notes at
www2.standardandpoors....

May 25 01:25 PM

[Fred Voetsch:]

On May 24 07:11 PM Prudent Man CFA wrote:

> Evidently none of the above in the seventies when the DJIA sold between
> 7 and 9 times earnings. At that time we were entering the technology
> age and our economy showed real growth. Where is the growth coming
> tomorrow?


I think this is a faulty argument. We had little new technology that was productive until well into the 1980's. Technology itself does not bring about prosperity andmay also lead to a decline of proserity. I offer World of Warcraft and Reality TV as an example.

The things that were different in the 1970's were demographics and the generational pattern. These are not easy things to explain but what we had was a young, growing population that was earning more and more all the time and would one day come to the point where a high percentage of them would come to live way beyond their means.

The 1970s was a time of high inflation and chaos as young Americans learned that they could "do anything and have anything" and certainly had no use for the morality and frugality of their parents, who were always going on about some despression and not having enough food to eat or something stupid like that.

The times they are a changin'.

Google: fourth turning; generational dynamics

May 25 01:37 PM

[Fred Voetsch:]

"With S&P earnings as of last Friday at $7.21, it will not take much improvement for the PE ratio of the market to be brought down by even a modest earnings improvement. For reference, last year at this time the S&P had earnings of $62 and sat at 1400 vs. 888 today. For the market to sit where it is and have its PE fall to around a more "normal" 20 times earnings, they must increase 485% to $45."


Each and every investor in stocks should have the following link bookmarked so that you can bypass the misinformation offered by Bloomberg, CNBC and The Wall Street Journal, all of which quote the S&P 500 P/E ratio at under 15.

www2.standardandpoors....

You will also hear quotes all day long about how earnings are outperforming yet this quote, directly from Standard & Poors...

"477 issues (97.98% mkt val) rptd: actuals are -24.4% off ests (see Energy note), and -43.8% behind last year (same issues, w/restatments)"

...cleary states that this is not the case.

Consider that this is the quarter in which AIG fed tens of billions, if not hundreds of billions of taxpayer dollars to financial institutions such as Goldman Sachs.

Consider Alt-A and other exotic mortgages that will soon be affecting earnings.

Consider that foreclosures are rising dramatically as moratoriums lapse. See
www.housingwire.com/20.../

Consider 500,000+ new unemployed each month.

Consider that the deleveraging of derivatives has not yet begun.

Consider that the deleveraging of consumer's balance sheets has just begun.

Consider that we the taxpayer now owe more than $10 trillion.

Consider that interest rates are at ZERO and have no where to go but up when the economy does start to pick up.

Consider that China's stimulus is driving up commodity prices which is exactly the opposite of what usually occurs towards the end of a recession.

Look around you: how many people do you know who are making long term changes in their lifestyles in order to pay down debt and keep it down and in order to be able to afford to retire some day?

Consider....

May 25 01:57 PM

[Fred Voetsch:]

On May 24 03:14 PM TheFounder wrote:

> The likely scenario is S&P earnings stabilizing at $45-50 and
> P/E at 12-15. That means a trading range of 540-750.


You mean RISE to $45-$50 as the only historically relevant earnings, as-reported, were at $15 for 2008 (12 month trailing) and are at $6.91 for Q1 2009 (12 month trailing) with 97% reporting.

If you are going to use a historical average of 15 for P/E then you must not mix apples with oranges and use operating earnings. Normalizing as-reported earnings might give you $30-$40, going forward, if you are realistic.

I think it is much more likely that with all the storms moving towards us we see another negative quarter or two or three of earnings before we start to see a real recovery.

What storms? Read my post above.

That just MY assestment, of course. I see the Dow below 5,000 by years end and likely well under 3,000 before we are through.

May 25 02:06 PM

[E Nuff Sed:]

With the glaring exception of Financials the P/E are holding up quite well inspite of the most serious recession after WWII.
Cyclical sectors such as industrials, materials, cons. disc. are behaving normally.
As an example look at the PG - now at a P/E of 14 is at cheapest on a P/E basis since the early 90's.
On the contrary this is a great market to pick up exceptional blue chips at more than fair prices (of course March was better - PG bottomed out at a P/E of 11).

May 25 10:38 PM

[Fighting Yoda:]

Can’t understand what the author is talking about and where he is getting his data. I don’t know why he is referring to quarterly and YTD earnings and such – makes no sense of any kind.

S&P consensus top down operating earnings forecast for 2009, as compiled and published by Standards & Poors stand at $ 42.93 on May 20. Top down operating earnings are the most popular form of estimates that are followed by the market.

Based on S&P 888 – current PE stands at 21. Too high.

2010 earnings forecast are - $46 – only 7% growth over 2009 est, PE 19.3 – a fantastic forward PE especially for a strong bear market.
What is normal PE? Average PE over last 50 years – 17.1, L10 PE (average PE of last 10 years – popularized by Robert Shiller) – 16.9. These are long term averages – don’t give a very good idea what it should be in the short term or in specific economic environments.
Bear market PEs have ranged from 6 -10. Average PE during the bear market 1974 – 1984 – 9.47, low of 7.3 in 1974, max of 12.4 in 1983.
Most experts attribute a PE of 10 for bear markets. Based on that current PE of 21 is way way too high.

May 26 12:55 AM