Jeffrey A. Miller

Fair Value for the S&P: It's Not 440

I'm not the brightest bulb in the chandelier so please explain what exactly, constitutes "normalized earnings"? (And why should I care?)Such a phrase suggests excluding events that are supposedly one off events. As is usual in such an circumstance that may make some sense such as a one time write down of the value of an investment. One concern is how often can we exclude such one time events that seem, curiously, to occur fairly often?

In the past I have used the reported operating earnings number to calculate a "fair value" for the S&P 500 using 10 year Tbill rates. That and $4 will get me a Starbucks latte. It is an interesting exercise but after a bit the thrill was gone. The market doesn't give two hoots about some academic assertion of "fair value". It does care about future earnings if investors have a long enough time horizon. Those with short time horizons are basically momemtum traders.

I have read that 2009 S&P 500 operating earnings (which excludes those 'one time events') may be in the $60 range. If I assign a 15 PE to that then fair value may be 900. If I assign a 10 PE then fair value is 600. It is not clear to me why a higher PE is reasonable for a seriously reduced earnings stream especially in an environment of extremely low interest rates. Yes, I understand the inverse might be more normal (low rates = higher PE) but those low rates are indicative of probable weak earnings not an harbinger of future gains.

Bottom line: while GAAP earnings include supposed one time events as if they were routine the 15 PE is overstating the future value of whatever the earnings will be.