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by Chris Turner

When questioned the other day about the relationship between trailing earnings and the S&P 500, I was inspired to create the chart below as a way to study the problem. The chart is based on Standard & Poor's Senior Index Analyst Howard Silverblatt's S&P earnings estimates spreadsheet. It shows the one-year trailing earnings for the S&P 500 in blue with a linear regression to highlight the trend.

The five-year average of trailing earnings in is shown in red. The Standard & Poor's one-year trailing estimates through 2012 are highlighted in yellow. The quarterly closes of the index itself are depicted in green.

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Some initial observations:

  • Trailing earnings peaks are increasing in frequency. The peak in earnings in 1989 and subsequent recession resulted in a small trough and a hiccup in the S&P 500. The next peak occurred in 2000, around ten years later with a larger correction in both earnings and the S&P 500 index. The next peak occurred in 2007, around seven years later, with a much sharper rise and a larger decline in both earnings and index values. What number comes next in the series puzzle: 10, 7, _? If the answer is 4, is that a clue that the next decline will begin in 2011?
  • Trailing earnings peak-to-trough are increasing in amplitude. This is especially conspicuous when you study the peak-to-trough declines and rebounds associated with the three recessions highlighted on the chart.
  • The five-year average of trailing earnings (in red) depicts earnings that should be around $60.00. That sounds about right and places a fair value around 900 (60 x 15 multiple). This would follow the long term historical earnings growth of around 6%.
  • The Standard & Poor's estimates (in yellow) peak in 2011 with essentially no growth going forward to 2012.

Conclusion? Pick your reasons for why earnings have increased in amplitude and frequency. Could it be an overactive Federal Reserve that is always late to either tighten or loosen policy, thereby exacerbating the rise and fall in both directions? Perhaps the rapid growth of securitization or derivatives and subsequent failures created the quicker peaks and troughs. Whatever your rationale, the inevitable downturn of the latest expanding earnings cone may not be pretty.