Since the closing high for the S&P 500 (SPY) of 2873 on January 26th, the market benchmark has sold off by over 9%. Stocks have fallen on a combination of trade fears, softening global economic data, and weakening risk sentiment. This sell-off has occurred under the backdrop of what is expected to be a strong quarter for corporate earnings.
Using Bloomberg estimates for forward earnings for the next four quarters, stocks are now trading at a forward earnings multiple of 16.6x after Friday's sell-off. Below, I have graphed this metric back to January 1990 - the longest stretch of data available for this forward earnings metric on Bloomberg. The metric now sits just above its average over this time horizon - the first time we have had below average forward earnings multiples since the first quarter of 2016.
Seeking Alpha readers tend to use differing sources and methodologies for price-earnings ratios. Some might use trailing instead of forward, different periodicities for earnings streams, operating versus GAAP earnings, and with and without extraordinary items to calculate their preferred P/E ratio. While our methodologies may differ, what the above analysis has is consistency. It is the same source for the data over a long-time horizon.
This data says that stocks are at least fairly valued over this dataset, a period where the S&P 500 has produced annualized returns of 9.9% including reinvested dividends. Inverting the 16.6x earnings multiple produces an earnings yield of just over 6%. This still compares favorably to a 10-year Treasury yield of around 2.8%. For this sample period, the 10-year Treasury yield has averaged 4.62%, so today's earnings yield still offers a decent equity risk premium.
No single metric can determine whether the stock market is rich or cheap. Amazingly, the forward earnings multiple for the S&P 500 when it hits its pre-crisis high of 1565 on October 9th, 2007 - 16.6x - is the same level at which we currently sit and close to this long-run average. Prognosticators at that time missed the coming economic recession and the lower earnings that accompanied that correction. Investors were paying too high a price for forward earnings that would come in far lower than expectations.
At today's forward earnings multiple, stocks look fairly valued. Juxtaposed against still low-interest rates, stocks still look cheap relative to lower risk alternatives like cash and bonds. Will earnings hit the forward projections baked into this multiple? Historically, prognosticators actually miss earnings projections too low as a higher proportion of companies beat estimates than miss. Ultimately, whether this forward earnings multiple proves too high or too low is a function of your view on the current state of the business cycle. If you believe we have longer to run, then stocks could prove to be modestly cheap here and offer above trend forward returns. If the economic cycle is drawing to the end - as it was in October 2007 - then the forward earnings multiple is misstated and could be pressed lower by share prices that fall further.
For investors with a long horizon, stocks look as cheap on a forward basis as they have in two years after this recent correction and are close to their longer-run average. Adjusted for below average interest rates, earnings yields look a tad on the cheap side. I hope this examination of forward earnings multiples provides value to Seeking Alpha readers as we seek to frame the evolving market environment.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore, inherently subject to numerous risks, uncertainties, and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.
Disclosure: I am/we are long SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
