Update to Market Valuation and PE

This is an update to my blog entry on market valuation that is important enough to reiterate and has additional details I am now willing to share with those who are not clients. Just as important are other thoughts that may have serious implications for the future that I will write about in coming weeks.

The following chart is simple to understand. The left column heading is the PE, the top row is the earnings of the S&P 500, and the intersection is the price the S&P 500 would be given those two factors.

The PE ratio says how many dollars investors will pay for one dollar of current earnings. When investors buy a stock (knowledgeably or not) they are buying a stream of earnings. When people are more risk averse, they will want more current earnings per dollar. The prior blog discusses historic trends in PE at market highs and lows. As noted at the beginning of the year Standard & Poors estimated that earnings this year would be around $40. Well, with 99% of companies reporting for Q1 '09 they overestimated by 25%. Overestimates are common with declining earnings as are underestimates with rising earnings. The band highlights the rough range of where the S&P 500 is today given various forward earnings.

As I hinted before, either investors must have an historically unprecedented appetite for stocks in a bear market (PE usually ends below 10), or earnings have to ramp up in an unprecedented manor to justify current levels, or a combination of both.

I have a hard time believing a person should invest betting on something that has never happened before without tremendous upside. In this case this unusual bet is only to justify current levels of the market, not forward growth.

The following chart shows the inverse relationship of 10 year forward returns on the stock market in red, and current PE ratio in blue. There are deviations, especially over the most recent 10 year periods, but the relationship is strongest at extremes of PE (shown here inversely). Source data: Robert Shiller http://www.irrationalexuberance.com/index.htm

If S&P is correct at $40 per share of earnings, the PE at current levels will almost match that at the top of the dot com bubble (shown here as the low side of the chart). As an investor in the market, are you right or is Standard and Poors? Or are you betting against history?

To find recent S&P 500 earnings information visit http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS

Historical average PE is 14.29
1918 down to 5.74
1924 9.05
1942 7.97
1949 6.62
1975 8.30
1982 7.73