While markets are by their very nature forward-looking, occasionally history can provide a context to what we are seeing in the present day. At year end 2011, the S&P 500 (SPY) level of 1257 was trading at 13.2x its trailing twelve month earnings multiple. This low of a P/E multiple has not been seen since the end of 1988, a prelude to a 27% price return on the S&P 500 in 1989.
Breaking the trailing fifty-four years of annual S&P 500 returns since the index's 1957 inception into quartiles by their trailing price-to-earnings ratio, once can see that this ratio seems to be strongly and negatively correlated with the magnitude of forward one year returns.
Year-end 2011's P/E ratio of 13.2x would put the ratio squarely between the top two quartiles of ascending price-to-earnings ratios. The years in the top two quartiles saw on average 12% price returns on the S&P 500 index over the next one year. The 27 years with relative P/E ratios in the bottom half of the sample saw only forward one-year returns of 3.99%.
Many market participants are forecasting falling S&P 500 earnings in 2012 as slowing economic growth in Europe and the developing world could dampen the prospects for U.S. multinationals. This begs the question, what type of negative earnings growth rate would we have to see in 2012 to drop the P/E ratio into the bottom two quartiles of the above chart, which has previously indicated sub-par forward returns? For the P/E ratio to drop to the 17.4x range, we would need S&P 500 earnings of $72.44 per share, a 23.8% decline from year-end 2011 levels.
Using historical context clues once again, have we ever seen this type of year-over-year decline in S&P 500 earnings? Only one occasion has seen the S&P 500 earnings drop so precipitously. The notorious 2008 calendar year saw negative earnings growth of -28.9%. Earnings in 2012 would have to drop just slightly more than the 2001 recession/deflating tech bubble/September 11th fallout quagmire.
While not all years with equivalently low price-to-earnings ratios have necessarily translated into above-average equity market returns, markets have outperformed on average when the index price has traded at this level relative to trailing earnings.
I hope that this analysis provides a broad framework to thinking about forward one-year S&P returns, and the type of discount that is potentially being priced into markets given continuing uncertainty regarding global growth.