One would think neutrinos affected the financial world as well with a Barron's title like, "A Market in the Twilight Zone." Strategists love to quote P/E multiples during these times, arguing that valuations are irrational based on a multiple of forward earnings estimates. In the article it is noted that the forward-looking valuation of the market today is approaching the valuation of the lows in 2009.
There are two fundamental problems with an analysis based on forward earnings. The first problem is typically the historical analysis is based on either the actual earnings for the "forward" year, or uses the low point of downward revisions of forward earnings. By using the actual figures instead of the changes in estimates as time moved through the year, the point is missed that the market was significantly over-valued at the start. The second problem is that forward earnings for the present situation may not yet reflect what the forward year looks like. Of course determining where forward estimates ultimately go is one of the main jobs of analysts, and one of the hardest.
As can be seen in the chart below, which was published on Dr. Ed Yardeni's blog, forward earnings in 2009 for the SP 500 started in 2008 around $120 per share before declining to below $60 by March 2009, about the time of the market bottom. In fact, the consensus estimate for 2009 SP 500 earnings was still above $100 near the end of 2008, highlighting how quickly an outlook can change.
Another takeaway from Dr. Yardeni's chart is the significant growth expected to continue in both 2011 and 2012. Earnings in 2011 ans 2012 are expected to grow well in the double digits. How is this possible when real US GDP growth has remained below 4% since 2009, has slowed to 1% in 2Q11, and is forecast to slow even further?
A large portion of the difference is the revenue US companies collect outside the country. The only problem is that foreign economies are stalling. Europe could enter a full-on depression, China is slowing significantly, and commodity-driven emerging markets are showing signs of problems. Looking from the top-down, it is difficult to find the source of the anticipated growth in profits.
Assuming the 2012 world economy is as bad as 2009, an assumption not unrealistic based on the on-going debt burdens in the world, forward earnings for 2012 likely decline again to $60. This suggests the current forward P/E for the SP 500 is 19x, hardly cheap by any historical measure. To use Thomas Lee's 12x multiple from the Barron's article on $60 earnings in 2012 suggests the SP 500 bottoms around 720.
During these unusual times it is helpful to refer to data that factors out economic cycles and inflation in order to reduce the noise level. For this analysis I refer to the Shiller PE Ratio, which bases PE on the average inflation-adjusted earnings from the previous 10 years. From the chart below one can see the SP 500 remains relatively high on a PE basis at 19x. A technical analyst might become worried about the trend of declining highs and declining lows. From a fundamental perspective, it is well above the 15x it touched in 2009 and the 5x for an all-time low. Again, this analysis suggests the SP 500 could fall to around 1,000 if it simply reverts to a historical median of 15.8x, and well below 1,000 if the economic slowdown mirrors the 1930's or 1970's.
Little things, like the pennies companies earn per share, have a tendency to upset our belief systems.
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