Monday, December 22, 2008

S&P P/E Insight

While reading through xTrends comments, I found an interesting analysis of the S&P 500 from a fundamental perspective.

Here's a slightly abridged version of eboro's original post:

"According to [Roubini, Shiller, and Shilling], there are essentially 3 types of earnings we should consider when measuring 'market climate' in a bear market. They include: Trailing Earnings, Peak Earnings and Normalized Earnings. The information below was taken directly from the S&P 500 data website:

Trailing EPS: $48
Peak EPS (2007): $84
Normalized EPS (5 Year): $65

Using data compiled by Shiller, let me point out the historic averages of each earnings multiple, as well as the levels they have often reached during cyclical bear movements in secular bear markets (often leading to the “bottoming process”). Note that I have adjusted them based on recent data:

Price to Trailing EPS: historic average of 16.5; bear market low levels of 12
Price to Peak EPS: historic average 13-14; bear market low levels of 7
Price to Normalized EPS: historic average of 15; bear market low levels of 10

Based on our different P/E types, and the levels they most often reach during bear market bottoms, we get the following numbers:

Using Trailing EPS: $48 x 12 = 576
Using Peak EPS: $84 x 7 = 588
Using Normalized EPS: $65 x 10 = 650

I do not think any of these numbers in isolation can effictively predict 'the bottom.' In fact, they are at best 'intelligent guesses' because there is no assurance that past multiples will be witnessed in this bear market, especially seeing as interest rates are so low. The important thing to remember is that they provide a 'probable range of outcomes'; we could see slightly lower earnings with higher multiples or vice versa (for instance, if 2009 earnings were to come in at $40 per share and the multiple was slightly higher around 14 or 15). In any case, if history is any indication, the S&P could reach a low range between 576 and 650, which implies downside risk of 27 to 36% from the current level of 900. Bottom line: the market may still be relatively expensive.

I think the lack of consistency amongst analysts concerning S&P P/E is a result of 'mixing and matching' different earnings with inapropriate multiples. I recently saw an analyst on CNBC claim that the market was cheap by using peak earnings with a bear market normalized earnings multiple. By doing this, she she inputed $84 x 12, thus estimating a value for the S&P around 1000. This methodology seems flawed for 2 reasons: she used only 1 type of earnings, she used the wrong multiple.

Thanks, E"

Thank you, eboro.

1 comment:

Anonymous said...

Nice post, was looking for data on this. tks