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  • Stocks could increase another 4% if analysts' expectations for growth are correct and P/E multiple remains constant.
  • S&P 500's price to forward reported earnings ratio is moderately below its median.
  • Downside risk is significant. S&P 500 would plummet 17% if earnings growth was only half of analysts' expectations and multiple contracted to 2009-2012 levels.
  • Despite the downside risk, S&P 500 still offers a more attractive risk to return tradeoff than other asset classes.

The market probably feels overvalued after the S&P 500's torrid 54% increase since the end of 2011. However, the valuation for stocks could still be reasonable by historical terms and very attractive relative to other asset classes. The paradox of a reasonable valuation following a period of sustained excess returns can be explained by the extremely low ratio of price-to-earnings at the end of 2011 and the subsequent resurgence in corporate profits. Today, the market's downside seems greater than its upside, but the risk return tradeoff for stocks is still better than that of bonds or real estate.

The chart below shows the ratio of the S&P 500's price to its earnings in the following year has increased slightly. Nevertheless, it remains well below the stratospheric peaks that preceded the Great Recession and the Bust.

Source: S&P Dow Jones Indices and Thomson Reuters

Several points are helpful to understanding the above graph.

  1. The chart graphs the S&P 500 at Dec. 31 to the reported earnings in the next year of the components of the index.
  2. Obviously, investors could only trade based on estimates of future earnings, and those estimates could vary significantly from actual results.
  3. Today's multiple is based on reported earnings for the 12 months ended March 31, 2014 multiplied by one plus analysts' consensus estimate for growth in operating earnings over the next four quarters. The consensus growth rate of 8.5% is above the historical average but not unreasonable.
  4. Reported earnings are lower and more volatile than operating earnings. Analysts tend to focus on operating earnings because they exclude one-time items and write-offs. However, omitting these charges fails to recognize the value that has been destroyed through restructurings, overpriced acquisitions and other mistakes. Over the past 25 years, operating earnings for the S&P 500 were $1,398 compared with reported earnings of only $1,198.
  5. The gap between reported earnings and operating earnings is widest during years when the market declines. The pronounced spikes in the above chart in 2001, 2002 and 2008 correspond to years when operating earnings were at least 57% greater than reported earnings.
  6. Today's multiple of 16.6 is moderately less than the median multiple over the past 25 years of 17.9.

The S&P 500 would increase more than 4% in the second half of 2014 if analysts are correct about earnings growth and the market's price-to-reported earnings multiple does not change.

S&P 500 on Dec. 31, 2014 = Market Multiple * 2015 Reported Earnings

2015 Reported Earnings = 2013 Reported Earnings * (1+ 2014 Growth Rate) * (1 + 2015 Growth Rate)

2015 Reported Earnings = 100.20 * (1 + 9.1%) * (1 + 11.2%) = 121.59

S&P 500 on Dec. 31, 2014 = 16.6 * 121.59 = 2,018

Increase from Today = 2,018 / 1,936 -1 = 4.3%

Source: S&P Dow Jones Indices

Unfortunately, the market's downside potential is significant. There are two sources. As mentioned earlier, analysts' estimates for earnings growth are somewhat aggressive. The geometric average earnings growth rate has been 5.9% and 7.5% over the past 25 years and 10 years, respectively. The chart below illustrates the tremendous volatility of reported earnings growth. There are a multitude of threats to earnings growth including soft demand in Europe, sluggish job growth and stagnant real wages. Consequently, it would not be surprising if the market's annual earnings growth in 2014 and 2015 was closer to the 5% reported in 1Q14 instead of analysts' estimates of 10%.

Contraction in the multiple of price to reported earnings is the other major threat to the market. Although the market is below the median of year-end multiples for the past 25 years, the year-end multiple was within a tight range of 14.2 to 14.5 between 2009 and 2012. The market would decline more than 17% if the multiple reverted to 14.5 and reported annual earnings growth slowed to 5% for 2014 and 2015.

S&P 500 on Dec. 31, 2014 = Market Multiple * 2015 Reported Earnings

2015 Reported Earnings = 2013 Reported Earnings * (1+ 2014 Growth Rate) * (1 + 2015 Growth Rate)

2015 Reported Earnings = 100.20 * (1 + 5%) * (1 + 5%) = 110.47

S&P 500 on Dec. 31, 2014 = 14.5 * 110.47 = 1,602

Increase from Today = 1,602 / 1,936 -1 = -17.3%

The potential for a 17% loss would cause even the most intrepid investor to pause; however, the valuation for stocks still seems compelling relative to bonds and real estate. The yield on 10 year U.S. Treasuries (10 UST) is extremely low by historical standards. Buying and holding 10 UST would generate an anemic 2.6% annual return. Another option is to buy 10 UST and sell when investing in the S&P 500 becomes more attractive. That strategy exposes the investor to interest rate risk. If interest rates rise 100 basis points in one year, investors who sell 10 UST would suffer a total return of negative 6% for the year they owned 10 UST.

While corporate bonds compare favorable to 10 UST, it's difficult to classify them as an attractive investment at this time. The spread between corporate bonds rated Baa and 10 UST is at its median for the past 25 years. However, the low yield on 10 UST means the yield on Baa is below average. Furthermore, the one year corporate default rate of 2.2% is still more than double its long-term average of 1.0%. Consequently, corporate bond investors are receiving a below average yield for an above average risk.

(click to enlarge)

Source: Federal Reserve Bank of St. Louis

Real estate is not as attractive an asset class as it was a couple years ago. The ratio of home prices to income is creeping back to its pre-crisis levels. This movement does not mean the housing markets are destined to crash, but it seems unlikely that the homes will record another year of mid to high single digit appreciation.

(click to enlarge)

Source: Federal Housing Finance Agency and Federal Reserve Bank of St. Louis


Stocks remain the most attractive asset class in terms of valuation. The price to forward reported earnings multiple of the S&P 500 is comfortably below its long-term median. Analysts are projecting at least two more years of above average earnings growth. Relative to other asset classes, the S&P 500 offers a better risk to return tradeoff. However, there are some risks. An earnings hiccup could make investors skittish and push the market's multiple back to its 2009-2012 level. This scenario would result in a 17% drop.

Source: Fundamentals Show Stocks Compare Favorably To Bonds And Real Estate, But Downside Is Significant