Secular stock market declines have ranged in length from over 19 years to as few as 3 [and] the current decline is now in its 10th year. Every time the P/E10 has fallen from the top to the 2nd quintile [as it has done recently], it has ultimately declined to the 1st quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require [either] an S&P 500 price decline below 540 [or] for corporate earnings to make a strong and prolonged surge. [Which is it going to be and, if it is the former, when might it occur? Only time will tell! Let me explain.] Words: 1338
Will The Stock Market (S&P 500) Sink To 540 – Or Will Corporate Earnings Surge?
So asks Doug Short (www.dshort.com) in an article* reformatted and edited […] below by Lorimer Wilson, editor of www.munKNEE.com, for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Short goes on to say:
As-reported Trailing Twelve Months Earnings
A standard way to investigate market valuation is to study the historic Price-to-Earnings (P/E) ratio using reported earnings for the trailing twelve months (TTM). Proponents of this approach ignore forward estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias. This market valuation method uses the most recent Standard & Poor’s “as reported” earnings and earnings estimates and the index monthly averages of daily closes for the month [which for] January 2011 was 1282.62. As such the TTM P/E ratio for January was 16.8 [1282.62 divided by 76.16]. For the latest earnings, see the adjacent table from Standard & Poor’s.
The “price” part of the P/E calculation is available in real time on TV and the Internet. The “earnings” part, however, is more difficult to find. The authoritative source is the Standard & Poor’s website, where the latest numbers are posted on the earnings page. [Should you go there] follow these steps to access the desired information: a) Click the S&P 500 link in the second column b) Click the plus symbol to the left of the “Download Index Data” title c) Click the Index Earnings link to download the Excel file. Once you’ve downloaded the spreadsheet, see the data in column D.
The table below shows the TTM earnings based on “as reported” earnings and a combination of “as reported” earnings and Standard & Poor’s estimates for “as reported” earnings for the next few quarters. The values for the months between are linear interpolations from the quarterly numbers.
The average P/E ratio since the 1870’s has been about 15. The disconnect between price and TTM earnings during much of 2009, [however,] was so extreme that the P/E ratio was in triple digits — as high as the 120s — in the Spring of 2009. In 1999, a few months before the top of the Tech Bubble, the conventional P/E ratio hit 34. It peaked close to 47 two years after the market topped out.
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As these examples illustrate, in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. “Why the lag?” you may wonder. “How can the P/E be at a record high after the price has fallen so far?” The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4… is something that has never happened before in the history of the S&P 500.
Let’s look at a chart to illustrate the irrelevance of the TTM P/E for a consistent indicator of market valuation.
The Cyclically Adjusted Price Earnings Ratio or P/E10 Ratio
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value… They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by a multi-year average of earnings and suggested 5, 7 or 10-years. In recent years, Yale professor Robert Shiller… reintroduced the concept… selecting 10 years as the earnings denominator. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic average is 16.35. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or the more precise P/E10, which is my preferred abbreviation.
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After dropping to 13.4 in March 2009, the P/E10 rebounded above 20. The chart below gives us a historical context for these numbers. The ratio in this chart is doubly smoothed (10-year average of earnings and monthly averages of daily closing prices). Thus the fluctuations during the month aren’t especially relevant (e.g., the difference between the monthly average and monthly close P/E10).
Of course, the historic P/E10 has never flat-lined on the average. On the contrary, over the long haul it swings dramatically between the over- and under-valued ranges. If we look at the major peaks and troughs in the P/E10, we see that the high during the Tech Bubble was the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant second. The secular bottoms in 1921, 1932, 1942 and 1982 saw P/E10 ratios in the single digits. [The current] P/E10 [as indicated above] is 23.3.
The P/E10 Ratio Using The ShadowStats Alternate CPI Suggests The Stock Market Is Fairly Priced
In response to the occasional request I receive for a real P/E10 based on the ShadowStats Alternate CPI for the inflation adjustment, see the chart below which suggests that the current market is fairly priced. On a personal note, I find the Alternate CPI version of the P/E10 interesting, but I think it is unreliable for estimating market valuation. Government policy, interest rates, and business decisions in general have been fundamentally driven by the official BLS inflation data, not the alternate CPI.
The Current P/E10 Ratio Suggests The Stock Market Is Expensive
For a more precise view of how today’s P/E10 relates to the past, our chart includes horizontal bands to divide the monthly valuations into quintiles — five groups, each with 20% of the total. Ratios in the top 20% suggest a highly overvalued market, the bottom 20% a highly undervalued market. What can we learn from this analysis? The Financial Crisis of 2008 triggered an accelerated decline toward value territory, with the ratio dropping to the upper second quintile in March 2009. The price rebound since the 2009 low pushed the ratio back into the top quintile. By this historic measure, the market is expensive.
We can also use a percentile analysis to put today’s market valuation in the historical context. As the chart below illustrates, latest P/E10 ratio is around the 87th percentile.
Secular declines have ranged in length from over 19 years to as few as three [and] the current decline is now in its tenth year. Every time the P/E10 has fallen from the top to the second quintile [as it has done recently to 87.1%], it has ultimately declined to the first quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require [either] an S&P 500 price decline below 540 [or] for corporate earnings to make a strong and prolonged surge.
[Which is it going to be and, if it is the former, when might it occur? Only time will tell!]
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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