Making Sense of the Market's Wacky Valuations

By David Berman

If you’re having a tough time figuring out whether the stock market is cheap or expensive, or neither, you’re probably not alone. Even strategists are having a tough time sizing up the market’s valuation relative to corporate earnings, simply because earnings over the past year have fluctuated tremendously and the future is fuzzy.

Trailing 12-month earnings used to give you a pretty good handle on valuation, but due to disastrous earnings in the fourth quarter of 2008 and the first quarter of 2009, the reading for the S&P 500 is currently 137-times earnings – absurdly higher than the long-term average, which is in the teens.

On the other hand, if you ignore the recent rough patch and focus instead on earnings potential, you can arrive at a price-to-earnings ratio as low as 12, which makes the S&P 500 look cheap – if the corporate earnings live up to their potential.

“PEs tend to be higher based on depressed EPS and lower based on peak EPS,” said David Bianco, chief U.S. equity strategist at Bank of America, in a note. “So attempting to navigate which widely fluctuating multiple to apply to a widely fluctuating EPS figure can prove to be nearly impossible.”

That said, Mr. Bianco hasn’t given up. He argued that stocks are driven in the near term by the market’s perception of normalized earnings – or what companies will generate when times are better. He believes that companies in the S&P 500 will generate earnings of $76 (U.S.) a share in 2010. That gives the S&P 500 a P/E of 14.5, based on Friday’s close.

But Mr. Bianco uses a so-called Fair P/E. This takes into account estimated long-term interest rates (about 2.5%) and the equity risk premium (about 3.5%), and gives him a Fair P/E of 16.5 for the S&P 500.

“Using our Fair P/E of 16.5-times earnings, the market is implying normalized earnings per share of $66.50, in line with the current quarter’s annualized EPS,” he said. “This suggests that investors consider the current quarter’s EPS to be normal. We disagree. We view current EPS levels to still be cyclically depressed and we expect the S&P to grind higher as investors raise their expectations for the S&P 500’s normalized earnings power to our $76 estimate.”

Comments

[David Van Knapp]

One strategist, one opinion. Make that "guess." Nobody, including you or me, knows (1) what the market's earnings will be in 2010, nor (2) what the market participants' millions of opinions will average out to be in creating the market's forward (or trailing) P/E. Nobody.

Mr. Bianco's opinions could turn out to be spot-on, or they could turn out to be 50% off. In fact, his opinions of both earnings and P/E could be off 50% in opposite directions, making his ultimate estimate for the S&P 500's level correct, but for the wrong reasons.

These things are fun to read and sometimes thought-provoking, but please don't rely on them for any decision you make. Do your own thinking, go with the trend (if there is one), and protect yourself on the downside in case you are wrong.

2009 Oct 19 05:30 PM

[Raymond Micaletti]

Bianco's assumption that long-term interest rates will be 2.5% seems fairly aggressive given that the 10-year yield is currently 3.4% and the 30-year yield is 4.2%. Anything that would drive long-term yields down to 2.5% level would likely take equities down as well. Perhaps he's referring to short-term interest rates (< 2 years) in the long-run?

2009 Oct 19 07:39 PM

[The Geoffster]

“By reading the characteristic features of any man's castles in the air you can make a shrewd guess as to his underlying desires which are frustrated.”
-John Dewey

2009 Oct 19 09:57 PM