S&P 500's PE Ratio of 139 Isn't Sustainable 34 comments
an article to
-
Font Size:
-
Print
- TweetThis
The S&P 500 PE ratio is an important determinant of the value of the stock market and the trend of the S&P 500. Historically, the S&P 500 PE ratio has a median of 15.7. Today, the S&P PE ratio is 139 based on a closing price of 1,044 on Friday, September 11, 2009. This assumes the trailing earnings for the S&P 500 companies as reported by Standard & Poor’s for the four quarters ending June 30, 2009. A PE ratio at 139 is not sustainable. What is a reasonable PE ratio for the S&P 500 given our current situation?
The S&P 500 PE ratio reflects the performance expectations of the stock market. In the last three quarters, the PE ratio has leapt higher with the plunge in earnings of the S&P 500 companies. The fall in earnings overcame the drop in the value of shares in early March 2009.
Even with the recovery in the markets since the lows in March, the S&P 500 PE ratio remains very high as the trailing four quarters of earnings is so low. According to data from Standard & Poor’s on the S&P 500, as reported earnings for 99% of all reporting companies, creates an S&P 500 PE ratio of 122.41 as of June 30, 2009. The trailing four quarters of earnings was $7.51. Two years ago the as reported earnings for the S&P 500 companies was $84.92 for the quarter ending on June 30, 2007. The S&P 500 PE ratio was 17.70. This plunge in earnings is what caused the S&P 500 PE ratio to rise so high.
As shown on the chart below the S&P 500 PE ratio rose to 122 for the quarter ending June 2009. The estimates through the end of 2010 are from Standard & Poor’s for earnings and the S&P PE ratio.
The U.S. has had three recessions since 1988 according to the National Bureau of Economic Research, the group that determines when the U.S. has had a recession. These recessions are depicted in red in each of the charts shown here.
click to enlarge
S&P 500 Earnings Forecast
Standard & Poor's has forecast earnings through the end of 2010. The chart below shows actual trailing annual earnings since the June 1990 through June 2009. It also includes the forecast for earnings through December 2010.
What stands out is the sudden jump in earnings that begins with the quarter ending December 2009. Part of this sudden change is due to the large drop in earnings reported for December 31, 2008. For the quarter ending December 31, 2009 the S&P 500 delivered $23.25 in losses for that quarter alone due to the large write-offs in the financial sector.
Once the major write-offs are no longer part of the four quarter trailing earnings, the annual earnings return to a forecasted $41 to $45 range for the S&P 500. This earnings forecast provides a basis to project what the S&P 500 index could achieve over the next 12 - 15 months.
Is the S&P 500 Going Higher or Lower
In the recession of 1990 – 1991, the S&P index began to climb before the end of the recession. Following the end of the 2001 recession, the S&P 500 fell another 200 points before rebounding. So far in the recession of 12/2007 - ?, the S&P 500 fell significantly and has turned up through June 2009. We know it is trading above 1,000 as of the middle of September 2009.
Looking at the earnings forecast from Standard & Poor’s we can assess which way the S&P 500 will likely move for the remainder of 2009 and all of 2010.
The table below uses the trailing four-quarter earnings from Standard & Poor’s. It then applies a PE ratio to derive the S&P 500 index forecast. When looking at the table, keep in mind that the median PE ratio is 15.7. In addition, the PE ratio is mean reverting, so we should expect it to fall further, possibly to 15 or lower. The very low S&P trailing earnings for June and September 2009 are due to the large loss reported in December 2008 quarter.
Using the December 2009 quarter the earnings forecast $39.35 and a PE ratio of 30 gives us a target price for the S&P 500 index of 1,181. On Friday September 11, 2009, the S&P closed at 1,044. A PE ratio of 25 gives us an S&P 500 index of 984. If the S&P 500 PE ratio remains between 25 and 30, we should see the S&P 500 index climb to a range of 1,146 to 1,375.
This examination of earnings and S&P PE ratios is telling us to expect a higher S&P 500 index throughout 2009, as long as the PE ratio remains in the 25-30 range. Whether this is correct, depends on several factors. First, are the earnings forecast correct? Investors should monitor earnings expectations throughout the year, looking for any changes either up or down. The estimates for all of 2010 are higher now than they were in June, indicating S&P is expecting a more robust recovery.
Second, evaluate your PE ratio assumptions based on the outlook for the economy and the markets. If earnings are running above the forecast from Standard & Poor’s, then you should could expect the PE ratio to hold in the 25 - 30. On the other hand, if earnings expectations are falling, then you should expect the PE ratio to fall further. In each case, any move in the PE ratio will cause a significant move in the S&P 500 index.
Yale University Professor Robert J. Shiller, author of Irrational Exuberance: Second Edition uses a modified PE ratio that smoothes out the volatility in the ratio. The denominator of this modified ratio is average inflation-adjusted earnings over the trailing 10 years. Shiller calls this modified ratio "p/e10." Using this data the modified ratio “p/e10” produces a PE ratio of slightly over 15, which is very close to the median of 15.7. In December 2007, the beginning of the current recession, the “p/e 10” was 25.95. Since markets tend to cycle above and below the median, we should expect the “p/e 10” to fall further before turning back up.
Using December 2009 trailing four-quarter earnings of $39.95 times the median PE ratio of 15.7 gives us an S&P 500 index of 627. This gives us a range for the S&P index of a high of 1,375 assuming an S&P PE ratio of 30 to a low of 675 with a PE ratio of 15.7, the median. The risk is to the down side.
Investors still need to understand if the S&P 500 PE ratio will rise or fall. If Professor Shiller is correct, then we should look for a drop in the S&P 500 PE ratio. On the other hand if the current PE ratio remains in the 25 - 30 range, then we could see the S&P 500 index rise further driven only by higher earnings.
For investors a PE ratio in the 25 to 30 range means it will be difficult to find bargains, as you cannot expect an expansion of the PE ratio to contribute a higher level on the S&P 500 index. Moreover, there is a risk the S&P PE ratio could contract, causing the level of the S&P 500 index to fall. A drop to 20 on the S&P 500 PE ratio gives us a high of 917 on the S&P 500, assuming earnings does not change from its forecast. Going forward investors need to keep in mind that the risk of a PE ratio contraction is a possibility. A rise in the S&P 500 PE ratio is unlikely.
Related Articles
|
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication in the last week
Seeking Alpha 100 » -
Fastest Climbers
Those with the largestSee all
increase in followers
in the last week
Fastest Climbers » -
Top Commenters
Top commenters,
as ranked by their peers-
1
User 353732
-
2
Moon Kil Woong
-
3
doubleguns
-
4
optionsgirl
-
5
Mayascribe
Top Commenters » -
1
-
Top Instabloggers
The 100 most activeSee all
Instabloggers.
Top Instabloggers » -
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
The 139 PE logic would be similar to owning $90 of a stock with a 15PE and $10 of a stock with a 200PE and saying your portfolio had a PE of 107. S&P lets a company with almost zero weight in their index wipe out the same dollar amount of earnings of a company with 100times the weight. It's amazing that they get it so wrong.
So, in my opinion, if the S&P falls 15-20% from here on growth worries, one might see more quantitative easing and packages which would further help boost the markets in a weak economy...
In my opinion, in a market where there is Government intervention, there is no relation at times between stock markets and economy and also valuation...
Here you will see that even estimated earnings for 2010 are very high.
www.crestmontresearch....
Since the future doesn't yet exist, only imagination is the limit when it comes to predicting the future. But eventually the future becomes present. And when that happens, then everyone realizes just how true and realistic their imagination of the future has been.
The thing to keep in mind about analysts and investors is that once in a while they are prone to have irrational exuberance. They start predicting a far brighter future than the one that's likely to come about. And this leads to a big disappointment, when the future arrives and it isn't nearly as good as everyone was expecting.
Most people, who are predicting a bright economic future now, have a very poor record of predicting the future accurately. And relying on their optimistic predictions now is no better than gambling.
Of course, if you see this all too clearly, Wall Street will always give you a pair of rose-colored glasses. Free.
www.distressedvolatili...
Any market index, when divorced from investor rationality or asset pricing logic, becomes a metric of willful delusion combined with deliberate distortion and force fed by a vast amount of nearly free money concentrated in the hands of the most active(and politically anointed) traders.
2. When ordinary investors have already experienced a lost decade,or worse, in their financial portfolios , are unable to get a return on cash or near cash assets and are very nervous about real estate investing , they become very susceptible to desperation about "making up" the loss in their financial assets(fear governs) and very anxious to find yield or capital gains somewhere, anywhere(greed governs). This is the case at present.
Combine the fear and greed of ordinary investors with the manifold corruption and deceits of Wash DC and Wall St and the complicit propaganda of the MSM(big recovery already here: get in now, get in big or be left behind and look very foolish; investment opportunity of a lifetime: one and only chance to make up for the lost decade) and ordinary investors can be herded into a financial box canyon with laughable ease. Once in the canyon they can be conveniently and massively slaughtered-----yet again.
Cru Jones - So, you don't think S&P knows how to calculate a P/E ratio? Let's see, they divide the total price of one share of stock for each company in the index and divide that by the total amount of earnings for one share of stock outstanding for all of the same companies. Bigger companies tend to have a lot more shares outstanding and therefore higher capitalizations. Thus, their earnings per share have a much higher weighting than the smaller companies that have fewer shares outstanding. The multiple is a simple measure of how much an investor is willing to pay for a given amount of earnings. The weighting isn't exactly perfect, but it does weight large cap stocks much, much more highly than relatively smaller cap stocks within the index. It does not, as you indicate, weight all stocks and earnings evenly. Remember, we are talking about the amount of earnings "per share" for a company. Weighting is accomplished by the variance in numbers of shares outstanding. Are you willing to pay more for $1 dollar of earnings of a big company than for a $1 of earnings of the smaller company with greater growth prospects? I hope not.
Too many ways to distort the E.
S&P ignores market caps because of the way it aggregates the earnings of all members of the index. If Exxon earns $10B for the quarter, and Jones Apparel loses $10B, the aggregate earnings - using S&P's methodology - will be $0. The only time market cap comes into play is during the calculation of the actual index value; a rise in Exxon's stock will affect the index more than the same percentage movement in Jones Apparel's stock.
I won't argue that finding the "perfect bargain" in today's market may be difficult; however, when is there ever such a thing?
Many value investors will pass on a growth stock that has a P/E ratio higher than a predetermined level. For example, they may discard all stocks that have a ratio of 15 or higher, no matter what industry group they come from. Some investors will discard any stocks that have P/E ratios above the industry group averages, concluding that they are grossly overvalued. I am not saying that this method doesn't work, because it does but it will not work when you focus on buying young innovative small cap stocks that are growing at tremendous rates, rates that "big caps" can no longer sustain.
I have never passed on buying a stock due to its P/E ratio being too high. What is too high? Too high to one investor may be low to another investor. This is the same logic that I use when speaking of stock’s prices. One problem that have with some value investors is their lack of understanding of the movement of the P/E ratio line on a chart. As a stock begins to move 100% or 200% from its pivot point, the P/E ratio will also move higher over the course of time. Plotting the P/E ratio on a chart will show you how much of a gain the ratio has made as the stock continues its up-trend.
----------------------...
Money without intelligence is like a car without a road.
www.intelligentinvesti...
On Sep 15 03:08 PM Mark Bern wrote:
> User 353732 - Well written comment that is right on the mark. <br/>
>
> Cru Jones - So, you don't think S&P knows how to calculate a
> P/E ratio? Let's see, they divide the total price of one share of
> stock for each company in the index and divide that by the total
> amount of earnings for one share of stock outstanding for all of
> the same companies. Bigger companies tend to have a lot more shares
> outstanding and therefore higher capitalizations. Thus, their earnings
> per share have a much higher weighting than the smaller companies
> that have fewer shares outstanding. The multiple is a simple measure
> of how much an investor is willing to pay for a given amount of earnings.
> The weighting isn't exactly perfect, but it does weight large cap
> stocks much, much more highly than relatively smaller cap stocks
> within the index. It does not, as you indicate, weight all stocks
> and earnings evenly. Remember, we are talking about the amount of
> earnings "per share" for a company. Weighting is accomplished by
> the variance in numbers of shares outstanding. Are you willing to
> pay more for $1 dollar of earnings of a big company than for a $1
> of earnings of the smaller company with greater growth prospects?
> I hope not.
In other words, come 1st qtr 2010, when the 4th qtr 2008 are no longer included, the P/E will 'suddenly change' back to it's normal range. Investors must always remember the P/E is a trailing indicator.
"Part of this sudden change is due to the large drop in earnings reported for December 31, 2008. For the quarter ending December"
Agree, P/E is quite a distorted indicator, it can be read or interpreted a million different ways, and rarely a good indicator for the next 3months - actually quite a poor one.
When Ebay or Yahoo were trading at P/E ratios around 150, in late 90s, it eventually collapsed later to low double digit, exept that in between, it went to 300 first.
I'd rather ride, and let the Bear write...
OK, fatal mistake in looking at that index P/E because it includes companies that are making losses, which distorts the P/E ratio much higher. As you know P/E's on a loss making companies are not meaningful. Last time I looked, Citigroup and General Motors were the main culprits distorting the index P/E.
A more meaningful index p/e is calculated by excluding any loss making companies (because these distort the p/e much higher).
** This is currently at 15.9x forward earnings for S&P500. **
I guess you also have to take into consideration that the index does have loss making companies in it but this calculation at least gives you a meaningful figure of what multiplier is being applied to the profitable stocks.
trick
I offer that cell D54 is a black swan freak and that the market correctly dismissed it as such. Did the editors choose your headline for you? If not, why the disconnect between the reasonably balanced article, and the hysterical headline?