The objective is to give investors an idea of where the index is currently in terms of valuation and also analyze if the 2010 earnings estimate for the S&P 500 index is realistic.
Since this article will be looking into the P/E based valuation for the S&P, I would like to point out certain facts about S&P earnings which are used to derive the P/E for the index.
The P/E that is generally calculated is done from the operating earnings of the S&P 500 companies.
The Operating earnings as defined by S&P is:
Income from product (goods and services), excludes corporate (M&A, financing, layoffs ), and unusual items.
So this generally excludes all unusual items or things like major write offs and other extraordinary expenses which do not recur or ideally should not recur in a normal business scenario.
However, in this article, I will be looking at P/E based valuations for the S&P based on the operating earnings as well as the reported earnings.
The Reported earnings as defined by S&P is:
Income from continuing operations, also known GAAP (Generally Accepted Accounting Principles) and As Reported
Reason for Analyzing S&P valuation using reported earnings:
The operating earnings eliminates the effect of one time items in its calculation. However, a lot of these one time expenses or major write off impacts the health of the Company. So it should also impact the valuation of the Company. But when these items are not taken into consideration, especially when most are negative, it does boost the earnings picture.
So in my opinion, it is fine to consider P/E valuation for the index based on operating earnings. But at the same time, P/E valuation based on actual earnings should also be highlighted. One can then leave it to investors to decide which number makes more sense to them.
S&P 500 PE ratio Chart (1988-2009):
In order to discuss the current valuation of the S&P in detail, I would take the help of the P/E chart for the S&P from 1988-2009. Given below are the charts for the P/E calculated from the operating earnings as well as the reported earnings for the S&P 500 stocks.
The P/E has been calculated on a quarterly basis and the earnings are of the trailing twelve months.
S&P 500 PE based on Operating earnings
S&P 500 earnings based on Reported Earnings
Key Observations based on the above Charts
- As on 30th June 2009, the S&P was trading at a P/E (As per TTM EPS) of 22.99 based on operating earnings. During the same period S&P 500 was trading at a P/E of 117.56 based on reported earnings.
- Currently (22nd August 2009) the S&P is trading at a P/E of 25.67 and 131.2 based on operating earnings and reported earnings respectively.
- Based on operating earnings, the S&P valuation has not gone above 29.5 (on a quarterly basis) since 1988. The S&P was trading at these valuations during the peak of the U.S. stock market bubble in the year 2000. Thus, the current P/E of 25.6, just one year after the world saw one of the worst financial crisis, is relatively very expensive in my opinion.
- The data looks even more interesting based on reported earnings of S&P 500 companies. The highest P/E (on a quarterly basis) based on reported earnings was 46.4 during 2001-02. Currently the S&P 500 is trading at a P/E of well over 100. Thus the S&P 500 index is terribly overvalued based on reported earnings.
One might argue that this is due to one or two time major write offs. But as I said before, even that affects the fundamentals of the Company and thus the returns to the shareholders. So it is always a good idea to take that into consideration as well in judging the valuation for the index.
Thus, in my opinion, the S&P 500 index is at overbought levels currently and a major correction should come relatively sooner. I don't predict a crash in the U.S markets or for that matter any market in the world. This is not because of great Company fundamentals or a very rapidly improving economy. It is just because of the huge liquidity that is present in the financial system that all asset markets will remain supported.
The S&P 500 Earnings Analysis
It is very interesting to look at the earnings estimates put forward by the S&P analyst for 2010. According to the estimates the operating earnings per share for the S&P 500 index for 2010 will be $73.05. Before I comment on this earnings estimate, I would like to present the historical operating earnings for the S&P 500 index.
- The S&P 500 index stocks earnings were at $76.4,$87.7 and $82.5 during 2005,2006 and 2007 respectively. This was the time when the whole world was at the peak of economic activity. It was one of the best times for Corporates globally. Thus, we can say that the S&P earnings peaked out at $87.7 during 2006.
- The healthy earnings of S&P during the period mentioned above was largely due to robust earnings from the financial sector, energy sector and also consumer discretionary sector.
- My concern about the S&P 500 earnings estimate arises from this fact. How can analyst predict earnings for 2010 for S&P to be 73.05 when we are just trying to get out of a major recession and when the health of financial companies is still a big concern. Coupled with this, the consumption has still shown no major signs of recovery. So how can S&P 2010 earnings be as good as (or close to) 2005-2007 earnings when none of these concerns were there.
- I would also like to mention that many analysts are talking about the recovery in the U.S economy which is evident from the fact that the economy shrunk only 1% in Q2 2009 as compared to 6.4% in Q1 2009. But what has led to this recovery? The answer is that the government sector has expanded while the private sector is still declining or just stabilizing. Clearly when we are talking about the S&P 500, we are talking about the private sector. So how can recovery for the private sector become suddenly so robust. I am very sure it will not be the case.
- So in my opinion, the S&P is discounting false earnings estimates for 2010. This makes the index even more overvalued and when the real earnings come in, the index will adjust accordingly.
- I must mention here that out of the 470 (out of 500 in the index) companies that have reported their Q2 2009 earnings so far, only 104 companies have reported sales growth and only 150 companies have reported actual earnings growth. So the picture does not look very rosy here.
In my opinion there are 2 factors which will lead to correction and resistance to move to higher levels for the S&P:
- A very high valuation in the markets as of now based on both operating earnings and reported earnings and
- A very high 2010 EPS estimate which is bound to dissapoint. When it does, then markets would correct accordingly.