Redux: Future S&P Returns Could Be Extraordinary

On June 18, 2009, we posted the article “Future S&P Returns Could be Extraordinary.” Although four plus months later hardly qualifies as the future, enough has changed to make it interesting to re-visit.

Figure one below reproduces our Graham Dodd adjusted earnings correlated graph dated June 15, 2009. As you can see, the S&P 500 was at 923.72, had a blended PE ratio of 17.3 and an earnings growth rate of 4.4%.

(click each figure to expand)

Fig. 1. S&P 500 20yr EPS & Price Correlation (Reproduced from June 18 Post)

Figure two below depicts an updated Graham Dodd adjusted earnings correlated graph through October 27, 2009. We used a shorter time frame, 1996 to current, in order to provide more detail. Note that the 2009 earnings estimate has been reduced from $58 (Figure one) to $57.17 (Figure 2). Also we now have a consensus estimate for 2010 S&P 500 earnings of $71.00.

Fig. 2. S&P 500 15yr EPS & Price Correlation

Since June 15, 2009 the S&P 500 blended PE ratio has expanded from 17.3 (the modern normal PE) to 19.1. This implies that at 1063.41 the S&P 500 value on 10/27/09 is slightly above its intrinsic value. On the other hand, applying the modern normal 17.4 PE ratio to the 2010 estimated $71.00 of earnings implies a year end 2010 intrinsic value of 1234.73.

Therefore, based on historical norms applied to consensus estimates the S&P 500 is moderately overvalued based on year end 2009 value, and offers attractive upside to year end 2010 value. Note that the 1234.73 intrinsic value listed above includes the S&P 500 PE ratio falling from its current 19.1 PE to its historical normal PE of 17.4, based on foreasted earnings.

Figure three below looks at the S&P 500 over the period 1996 to 2006. This is pre –the great recession and is offered to reflect the historical normal earnings growth for the S&P 500. This period includes the infamous “irrational exuberance” period 1996-2000 and the recession of 2001. Note the 9.4% (7-10 Hist.) more normal Earnings Growth rate.

Fig. 3. S&P 500 1996-2006 EPS & Price Correlation

Our final graph, figure 4 below, depicts a five year forecast for the S&P 500 earnings based on a more normal 8% growth rate following a return to near($85.91 EST. vs $87.72 2006 Actual ) 2006 S&P 500 reported earnings. This implies an S&P 500 value just north of 1900 by year end 2014. This is not our forecast, as we don’t forecast the stock market. This is merely a mathematical representation of an S&P 500 achieving normal growth & values from today’s levels.

Fig. 4. S&P 500 EPS Forecast

CONCLUSION

The majority of the discussion in this article and its predecessor, dated June 18, 2009, is based on historical fact. The earnings correlated graphs are based on facts as reported and drawn with mathematical calculations based on those facts. They are not manipulated or altered. Consequently, we believe they tell a compelling and undeniable story to those willing to study them closely.

To us, they are what they are, and not really subject to debate. Of course this does not apply to the forecasting charts or the data points on the historical graphs marked with an E for estimate. That information is based on estimates and therefore open to debate.

Our point is straight forward. In our view, there is a profound perspective that is gleamed from the facts as they exist. For example, the irrational exuberant period of 1996 to 2000 clearly indicates aberrant overvaluation. Most importantly this overvaluation explains the majority of the S&P 500’s poor performance over the last 10-15 years.

In our view, the undeniable correlation between the rate of change of earnings growth and price is clearly evident. Most importantly, the past twenty years refutes the efficient market hypothesis. There are many years where the market was clearly inefficiently overpricing stocks.

On the other hand, and perhaps equally as important, the evidence supports the hypothesis of a market seeking efficiency. In other words, when values get out of wack, there will inevitably be a reversion to the mean.

Many will continue to obsess with short-term forecasts regarding how the so called market (S&P 500) may or may not behave in the near future. Also, many will continue to draw technical charts based on price volatility, while ignoring the more important fundamental principles.

There will continue to be doom and gloomers and wide eyed optimists as well, yet the world belongs to the pragmatists. As the venerable Warren Buffett so aptly put it in a recent interview, “the world works.” Let the market march on.

Full Disclosure: No index ownership at time of writing - We only buy individual equities.

Comments

[Bruce Pile:]

The point you are making is exactly the one John Bogle makes with the chart he shows in one of his books (Common Sense On Mutual Funds I think it was) where the price of the stock market is plotted vs the total of the constituent companies' earnings/share and their dividend payout. This was graphed over some 100+ years. The two lines stray only slightly from each other over the years and form a pretty tightly intertwined pair and wind up at the same destination after 100 years! The charts you show are just a small section of this 100 year view.

It would be nice if this would continue as it has for decades and our stocks would follow the money higher. But so much of "the money" lately is being created out of thin air with government printing presses and an out-of-control parabolic debt curve. This will become more unstable and breakdown at some point unless it is fixed soon.

Oct 29 11:31 AM

[Dave Wrixon:]

Extraordinary is a given. Just not Good.

Oct 29 11:55 AM

[Mistrofan:]

If 6.5% over the next 2 years can be called Extraordinary - then yes. I won't even say what the return will be over the next 5 years - Let me just say that will be negative.

Oct 29 12:14 PM

[Michael Clark:]

Night-Cycles return nothing.

Recent Night-Cycles: 1929-1947; 1965-1983; 2001-2019.

Day-Cycles return extraordinary returns.

Recent Day-Cycles: 1911-1929; 1947-1965; 1983-2001.

We're not going to make much of anything except by trading stocks through 2019.

Oct 29 12:49 PM

[granger:]

Thank you, great information

Oct 31 12:56 AM