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S&P 500: Which Earnings Are Most Relevant to Its Performance?

Tom,
Thanks for your reply.

While I would normally agree lower interest rates would significantly boost the S&P, as they have done historically, I really do think this time it's different. That's because banks are still not lending freely and credit is tight, despite the low interest rates. In the past the low level of interest rates ( which implies easy credit conditions) are bullish for the stock market because it allows busineses to expand freely. That's certainly not the case this time.

The reason I suggested the line should be shifted downward (and a dummy variable used for the clearly outlying data points such as near the 2000 stock market peak) that at least in the next 10-20 years it's doubtful that p/e's will get that stupidly high. Those data points shift the regression line up considerably.

Using the unemployment rates makes sense to me. Typically p/e's are highest during trough earnings, and trough earnings correlate well (with some time adjustment) to the highest rates of unemployment.

S&P 500: Which Earnings Are Most Relevant to Its Performance?

I calculated the fair value of the S&P using your formula and the latest release of NIPA profits and came up with an S&P level of 1165. However, I noticed something rereading the article that I missed earlier. It related to your second graph and the regression.

Obviously the S&P was too highly valued in the 2000 (1999-2002?) period relative to NIPA profits and that shifts the line upward. You have these dates circled on the graph. What if you ran the correlation again using a dummy variable for the obvious outlyers (including those two below the line in graph 2 as well)? That would shift the regression equation line downward by ?. Just eyeballing it that could reduce the S&P fair value by at least 100 points, perhaps more.

Hopefully you will see this comment and reply. Thank you again for a great article.

S&P 500: Which Earnings Are Most Relevant to Its Performance?

Very interesting, thought provoking article.

One comment/criticism. You are using twenty years of data for the correlation, and in that period credit became easier and tax policy better for the investor and corporations, with leverage also increasing.

Going forward that will certainly not be the case. If you can find longer history which includes more adverse conditions (credit, taxes, etc) and the correlation still holds - then you have a winner!

My gut says that the more adverse credit and tax situations should slow corporate profits and a market unwillingness to pay the multiples seen during that 20 year period you studied. Hence, the correlation should break down. But thanks for the heads up; I'll pay more attention to NIPA corporate profits in the future.

Stock Valuations On the Rise

Your P/E exercise is misleading and therefore worthless since it conveys the idea the stock market is expensive.

The s&p p/e is high because the "e" in both the financial and consumer discretionary areas have fallen, and these two sectors make up about 29% of the s&p (as of Sept 2007 although it's probably lower today). When one takes a look at the other sectors, where earnings are actually growing because they are heavily tied to the world export market, p/e's are not particularly high on a historical basis and in most cases are lower than a year ago. This was especially true before the latest rally.

Technical No-No: S&P 500's 50-DMA Close to Crossing Below Its 200-DMA

So, out of the 36 crossovers, 19 were lower a month and a quarter later. That's little better than tossing a coin. And I should care about this? Did you even notice it seemed to work much better prior to 1970 than after? Perhaps, like everything else, when people "gamble on it" it doesn't pay off?