On September 5, 2010 we published an article on Seeking Alpha that suggested that the S&P 500 would reach 1245 by year end. This forecast was based on the S&P 500 trading at its 80 year historical normal PE ratio of 15 and a consensus earnings forecast for calendar year 2010 of $82.98. Below is the earnings and price correlated F.A.S.T. Graph™ dated September 1, 2010 that graphically portrayed our forecast based on the numbers. On October 29, 2010, Standard & Poor's Corp. updated the earnings estimate for the S&P 500 for calendar year 2010 to $83.62, or $.64 higher. As you can see from the chart below the S&P was at 1080.29 when the article was first published.
9/5/2010-Why the S&P 500 Should Reach 1245 by Year-End 2010 (Click to enlarge)
As you can see from the updated F.A.S.T. Graph below, the new forecast for the S&P 500 based on the updated increased earnings estimate has risen to 1254.22, or 9.52 points higher than the September forecast. Although these numbers are essentially the same, since the new forecast is only slightly higher, you can see from the graph below that the S&P 500 stock price (black line) is tracking the earnings justified valuation line (orange line) as forecast. Therefore, with only two months left the principle that earnings determine market price is thus far holding true.
S&P 500 20yr. Earnings Correlated to Price, 11/1/2010 (Click to enlarge)
One of the most interesting takeaways from the above graph is how the S&P 500's price earnings ratio has really not fallen below its 80 year historical fair value PE of 15. When the stock price fell precipitously it was due to a drop in earnings, not a reduction in the PE ratio. From this observation, it is reasonable to assume that the historical normal PE ratio of 15 is a pretty solid metric for investors to hang their hat on.
The big risk would be that earnings collapse rather than the PE ratio falling below 15. With the S&P 500 currently valued precisely at 15 times blended estimated earnings, it would seem that this important index is fairly priced today. It will be interesting to see how the next two months turn out and whether the earnings forecast of $83.62 holds and the 1254.22 level is reached.
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Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.