Excerpt from the Hussman Funds' Weekly Market Comment (1/18/11):
As a reminder of how we approach market valuation, we strongly believe that securities are a claim to a stream of future cash flows that can actually be expected to be delivered to investors over time. As a result, we have little sympathy (and history demonstrates little sympathy) for the popular but misguided practice of applying arbitrary valuation multiples to forward analyst estimates of earnings. Generally, these "forward earnings" estimates fail to normalize for fluctuations in profit margins, return on equity, and other factors that have historically driven short-term earnings temporarily above and below levels that that would have a stable, proportional relationship with the present value of subsequent cash flows. Forward operating earnings estimates are more volatile and more influenced by recent short-term behavior than can properly be used as a basis for valuation, and the resulting earnings "misses" can be particularly extreme at turning points.
In the graph below, you'll notice that the prior peak for S&P 500 trailing net earnings has often been a reasonable "rule of thumb" estimate of normalized earnings, but in recent years, temporary spikes in profit margins have periodically driven peak earnings briefly above properly normalized levels. For that reason, as I wrote several years ago, prior peak earnings have become increasingly unreliable. This is particularly true given the actual destruction of book value and revenue in recent years. It's certainly possible to debate the precise level of normalized earnings here, but somewhere in the $70-$75 range, which is where we are at present, is roughly accurate on a trailing net basis. Our estimates also assume continued future long-term growth of slightly more than 6% annually, as reflected by the red channels.
Importantly, since our normalized figure tends to run with earnings peaks rather than earnings troughs, the corresponding multiple applicable to these earnings has historically been less than 14 (and was actually closer to 12 in pre-bubble data, which was typically associated with long-term total returns near 10% annually). Since "forward operating" earnings are typically about 20% higher than trailing net, the resulting historical P/E "norms" should also be adjusted accordingly (which analysts rarely do). None of this is to say that the earnings peak during the current economic cycle has to be limited to the present level of normalized earnings - just that more elevated earnings would not be an appropriate basis on which to compute the long-term value of stocks.