What is the PE Ratio telling us now?

by Hans Wagner, TradingOnlineMarkets.com | February 26, 2009

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Quick question. Is the current S&P 500 PE ratio trending down or up? If you are like most investors, you believe the S&P 500 PE ratio is trending down as the stock market plunges. After all, the P part of the ratio is dropping.

In this case, you would be wrong. It turns out that the denominator E or earnings in the PE ratio are falling faster. In fact, with 92% of all S&P 500 companies reporting, the earnings are a -$11.82 according to Standard & Poor’s. This means the S&P 500 PE ratio is rising reaching $29.19 for the quarter ending December 2008 as shown with the black vertical line in the chart below.

It is interesting to note that the forecast for the S&P 500 Index PE ratio rises so much in 2009. This is driven by two factors. First, Standard & Poor’s forecasts $32.41 earnings for the index. This is the lowest since the early 1990’s when the S&P traded in the 400 to 600 range. Second, to calculate the PE ratio, Standard & Poor’s uses the most recent closing price for the index, which was 788.42 on February 18, 2009. By holding the P constant and lowering the E, you have to get a higher PE ratio.

As we have seen, PE ratios often rise sharply following a recession. Several quarters after the recession is over, the PE ratio turns back down, reflecting the rise in earnings, with the price either remaining constant or continuing to fall.

Yale University Professor Robert J. Shiller, author of Irrational Exuberance: Second Edition uses a modified PE ratio that smoothes out the volatility in the ratio. The denominator of this modified ratio is average inflation-adjusted earnings over the trailing 10 years. Shiller calls this modified ratio "p/e10." Using this data the modified ratio “p/e10” produces a PE ratio of slightly over 15, which is very close to the median of 15.7. In December 2007, the beginning of the current recession, the “p/e10” was 25.95. Since markets tend to cycle above and below the median, we should expect the “p/e 10” to fall further before turning back up.

Is the S&P 500 Going Lower

The U.S. has had three recessions since 1988 according to the National Bureau of Economic Research, the group that determines when the U.S. has had a recession. These recessions are depicted in the chart above in red. In the recession of 1990 – 1991, the PE ratio began to climb before the end of the recession. Following the end of the 2001 recession, the S&P 500 fell another 200 points before rebounding. So far in the recession of 12/2007 - ?, the S&P 500 has continued to fall.

Does this mean the market is going lower? Not necessarily. As shown in the chart of the S&P 500 index below, the index continued to retreat after the 2001 recession. On the other hand after the recession of 1990 – 1991, the S&P 500 rose slowly. Besides, we do not know when the current recession will end.

Looking at the earnings forecast from Standard & Poor’s we might be able to assess which way the S&P 500 will likely move. The table below uses the trailing four-quarter earnings from Standard & Poor’s. It then applies a PE ratio to derive the S&P 500 index. When looking at the table, keep in mind that the median PE ratio is 15.7. The PE ratio is mean reverting, so we should expect it to fall further, possibly to 10.

S&P 500 Index Projections

Quarter	S&P Trailing Earnings	PE Ratio
		10	12	15	17	20	25	30
12/31/2010	$38.76	388	465	581	659	775	969	1,163
09/30/2010	$37.36	374	448	560	635	747	934	1,121
06/30/2010	$34.58	346	415	519	588	692	865	1,038
03/30/2010	$32.41	324	389	486	551	648	810	972
12/31/2009	$13.47	135	162	202	229	269	337	404
09/30/2009	$15.22	152	183	228	259	304	381	457
06/30/2009	$19.83	198	238	298	337	397	496	595
03/31/2009	$27.01	270	324	405	459	540	675	810

In the upcoming March 2009 quarter, the earnings forecast are $27.01. A PE ratio of 25 gives us a target price for the S&P 500 index of 675. On Friday, February 20, 2009, the S&P closed at 770.

The S&P trailing earnings falls throughout 2009, placing further downward pressure on the S&P 500 index. The falling earnings are due to the negative earnings for the fourth quarter 2008 and the low earnings forecast for all of 2009. With a PE ratio of 30, the S&P could fall to 404, far below the current level.

This examination of earnings and PE ratios is telling us to expect a lower S&P 500 index throughout 2009. How far it will go down depends on several factors. First, are the earnings forecast correct? Investors should monitor earnings expectations throughout the year, looking for any changes either up or down. Often estimates tend to overshoot on the up side toward the end of a booming economy and undershoot as a recession ends.

Second, evaluate your PE assumptions based on the outlook for the economy and the markets. If earnings are running above the forecast from Standard & Poor’s, then you should expect the PE ratio to rise eventually. On the other hand, if earnings expectations are falling, then you should expect the PE ratio fall further. In each case, any move in the PE ratio will tend to move more slowly.

Given the current view of the economy and the markets, I am expecting the PE ratio to remain high, above 30 and likely reaching 50, as earnings remain low. A PE of 50 in the fourth quarter of 2009 would mean the S&P 500 would trade at 673, 100 points lower than the current level. Along the way, we could see the S&P 500 fall to as low 600, as the market adapts to lower earnings and muted prospects.

As investors, we should assume that the trend for the S&P 500 is still down. It will be important to monitor the performance of the S&P 500 companies earnings announcements during the next several quarters to see how they match up to the forecast.

 

Copyright © 2009 Hans Wagner
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If you wish to learn more on evaluating the market cycles, I suggest you read:

Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis is an excellent book on how to predict macro moves of the market.

Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling.  One of the best, easy-to-read, study of stock market cycles of which I know.

The Disciplined Trader: Developing Winning Attitudes by Mark Douglas.  Controlling ones attitudes and emotions are crucial if you are to be a successful trader.

Bio As a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market. Feel free to visit the site at http://www.tradingonlinemarkets.com/ 

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Hans Wagner | Colorado, USA | Email | Website

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