S&P 500 P/E Mean Reversion: Pick Your Poison - Is The Market Cheap Or Expensive?

Includes: IVV, SPY, VOO
by: Richard Shaw

Investors are faced with analysts with strong convictions for the S&P 500 in 2012 potentially reaching lows of about 950 or highs of about 1400, from the current mid-1200s. They all have interesting arguments.

One of the arguments is mean reversion. Unfortunately, some see mean reversion taking the index higher (the market is cheap), while others see mean reversion taking the index lower (the market is expensive).

This chart of cyclically adjusted S&P 500 P/E ratios, using data from R. Shiller, for about 130 years, may illustrate the point.

click image to enlarge

Click to enlarge

The chart plots the inflation adjusted long-term normalized earnings P/E of the S&P 500 index (blue line). It also plots the 10-year moving average of the P/E (red line), the average of all P/E's since 1881 (solid black line), and the linear regression best fit trend line (dashed black line).

Depending on what you mean by "mean," this chart tells you the S&P 500 is either cheap or expensive, depending on what you think defines the mean.

The 130-year average is about 16.4. The current normalized P/E is about 20.8. The 10-year average is about 23.4, and the linear regression best fit is a bit higher than the current P/E.

You might pick some other basis for determining a mean (and you may not believe in Shiller's normalization approach), but these data, for example, could be used to project a 20% decline or a 13% rise in the index. That would define a range from about 1020 to about 1435, which happens to be the range that captures most of the pundits predictions.

There are certainly other dimensions to consider in making projections - including choosing not to make projections - but this one is far more appealing in logical discussion than it is in actual practice.

We believe in mean reversion, but its implementation is not as simple as its expression. Taken in conjunction with other independent factors, it may be more helpful.

We happen to be tilted somewhat toward the doubters camp.

There are signs of improvement in the U.S. economy, but the world economy is slowing according to various experts, including the IMF. Important well known problem issues in Europe, China and the U.S. are not resolved. The Middle East is still a wild card, as it may relate to oil prices and their impact on the world economy.

And, importantly, we think trees don't grow to the sky. The earnings of the S&P 500 have come back to record levels and the projections for growth are hefty. When companies begin hiring again, and as interest rates rise again, the profit margins of companies are likely to contract. That would tend to push P/E multiples down.

On the other hand, investors can't live in fear of the next 2008 forever. Something other than holding zero interest cash in a 3% inflation environment must be done.

So far, we hold a balance of cash, stocks and bonds, with an emphasis on financially strong, brand dominant, global companies, with above average dividends and a pattern of dividend growth, and good earnings and cash flow coverage of the dividend stream.

We know that the drum beat for dividends has become quite loud, and there are expressed concerns that the dividend approach has become crowded. But with selection, we think good opportunities for income growth still exist.

Investors with dividends sufficient to meet cash withdrawal needs can take a much longer view and remain emotionally stable during market volatility, in the knowledge that cash distributions keep coming their way.

Directly Related ETFs: SPY, IVV, VOO.

Disclosure: QVM does not have positions in any mentioned security as of the creation date of this article (January 8, 2012).

Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.