Earnings and the S&P: Not a Pretty Picture

Includes: DIA, IWM, QQQ, SPY
by: Price Headley, CFA

While the bulk of our work here at BigTrends.com is chart-focused, there’s nothing wrong with adding other layers of analysis to a broad trading plan. In fact, we’d suggest anything that gives technical trading an edge is a worthy pursuit. So, with that as a backdrop, let’s take a step back and post some thoughts about the market’s overall valuation... past and projected. It’s a bit of an eye-opener that may have you rethinking your long-term investing strategy.

The Ultimate Arbiter

When it comes to fundamental analysis, in the end there’s really one key driver of a stock’s price… earnings. Though it’s not without its faults as a valuation measure - that’s why the P/E ratio is such a common consideration - it shows you precisely what you’re paying for profits.

The same valuation analysis can be applied to the broad market as well, which is what we did below; we determined the S&P 500’s value, as measured by its price/earnings ratio on a historical, present and projected future basis.

On the lower portion of the S&P 500 chart below, we’ve laid out the S&P 500’s operating and GAAP earnings per share - assuming the index was a company - going back several years (the key is on the chart itself). Additionally, we’ve added the projected operating and reported earnings for as much time as we had access to…. through 2010, or 2011, depending on the data in question. The dashed lines are the average readings for their respective data sets.

It doesn’t take long to see a handful of moderately-alarming problems. Take a look, and then keep reading. (Click to enlarge)

S&P 500 Monthly Chart with Reported and Operating P/E Ratios

Did You Notice?

So what’s the chart telling us about what the Standard & Poor’s opinion of the future? A couple of details really stand out, but a couple of observations are in order first…

1. Acceptable P/E ratios tend to be lower coming out of recessions and as we enter expansion phases, and tend to be higher in the latter stages of a bull market. For instance, the S&P 500’s operating P/E fell to a low of 15.16 in mid 2006, and a low of 14.41 in late 1994. Yet, actual earnings had been firmly on the rise for months before those P/Es were reached.

Why this is bad for the market: In simplest terms, even strong earnings results (which we’re seeing again) may not push stocks up to valuations we were used to in 2007, or in 1997/1998. Many stocks may be ‘cheap’, but may stay cheap – with low prices – for a while. This is probably the result of fear or shellshock.

2. There’s a big projected divergence between GAAP and operating earnings. How long can all these one-time charges last? Though operating earnings (red) are expected to reach $20.73 per share (per quarter) by the end of 2010, where they were in early 2006, GAAP (or actual) earnings are only expected to reach $14.82 per share by the end of 2010, where they were in early 2005.

Why this is bad for the market: The smoke and mirrors can only persist for so long before investors grow weary of accounting maneuvers disguising reality. If companies are only really earning at 2005 levels, can we expect stocks to be significantly greater than 2005 prices?

Crunching the Numbers
Read much more below:

So, with those two ideas bouncing around in your head, what’s this chart telling us about where the market’s valued now, and what’s it’s likely to be valued at over the next two years?

Assuming the post-recession operating P/E will sink to, say 14.8 as it has after the prior two recessions, and assuming the S&P 500 generates quarterly operating earnings per-share of $20.73 by the end of 2010, that translates into a justifiable value of 1227.0 [$20.73 per quarter, multiplied by 4 quarters to annualize it, and then multiply by the P/E ratio of 14.8]. That would mean about a 12% increase in its current value, which isn’t bad, but nothing earth-shattering either. And, there’s little room for error or shortfalls.

And what about a GAAP-based valuation? Let’s go through the same math, bearing in mind we actually have two years of data to work with – this is a model for the S&P 500 at the end of 2011.

Assuming the post-recession GAAP P/E will sink to the average of 16.01 by the latter part of 2011 (it reached 17.11 and 15.04 just after the mid-points of the prior two recessions), and assuming the S&P 500 generates the anticipated quarterly reported/GAAP earnings per-share of $17.41 by the end of 2011, then we can only justify a valuation of 1114.0 [$17.41 per quarter, multiplied by 4 quarters to annualize it, and then multiply by the P/E ratio of 16.01]. That would mean about a 2% increase in the S&P 500’s current value... two years from now!

So which forecast price is the right one? Neither. Both. Maybe somewhere in between. That’s not the point really; we’re just trying to give you a general idea of what the most-likely scenario is... which is fairly uncompelling for buy-and-hold long-term investors as of right now.

Put It In Perspective

We don’t mean to sound alarmist. The fact is, earnings are getting better (real and operating), and the economy is not falling apart at the seams any longer. As such, the market is no longer an inherent liability. That’s good news for everyone, traders and investors alike. And who knows? Standard & Poor’s will certainly update their expectations as time progresses – maybe for the better.

On the other hand, whether you view things from an operating or a GAAP perspective, the market is likely going to be a tepid mover - at best - for a while.

Though it may a tad self-serving, this is precisely why we choose to trade shorter-term in BOTH directions through the use of Options and ETFs, and choose to teach others to trade as well. Long-term buy-and-holders may find the next two years are wasted if they simply sit on their hands.

For those who pro-actively seek opportunities, and are willing to move on them (and exit them) as merited, this rebounding market (and volatile moves within ranges) should serve up enough short-term trading opportunities to keep active investors making forward progress.

Disclosure: No positions

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