Guest post by Wayne Whaley, CTA
Valuation is a funny bird because we are forced to use trailing information to attempt to estimate whether the market is fairly priced relative to future information (earnings) and there is substantial guesswork involved.
This allows analysts a great deal of flexibility to mode the statistics to serve one’s agenda. I read an article published on Oct 23rd in a prominent online finance page that stated that the bulls should be disturbed to buy the stock market at 136 times earnings. That article prompted me do the following mental gymnastics.
What we do know for a fact:
So using the trailing 12 months earnings of $7.51 for the four quarters that we have full earnings for and the S&P 500 value as I type of 1050.0, we have a market trading at a P/E of (1050.0 divided by 7.51) 139.8 times earnings.
If I read their website correctly, Standard and Poor’s estimates that with 37% of companies 09 third quarter earnings in, that the 3rd quarter estimate is $13.14. This would take the trailing 12 month earnings to $10.92 at the end of the third quarter and put the current P/E at 1050/10.92 = 96.1 times trailing earnings.
But the big change comes at the end of the year. We will drop the -$23.25 during the height of banking crisis and add some number likely to come in between 10 and 15. To avoid picking numbers to serve our purpose, let’s be conservative and assume $10 a share for the fourth quarter. This would take earnings for 2009 to (7.52+13.51+13.14+10) = $44.17. With the S&P 500 at 1050, that would give us a conservative estimate of P/E for 2009 of 1050/44.17 = 23.77, a tad bit below the current +100.
A P/E of 23.77 is above the historic norm of 19, but inverts to an earnings yield equivalent of 4.2% which is equivalent to the current return of the 30 year bond and higher than any other return on the shorter end of the yield curve.
This is justified by a more detailed look at earnings vs. interest rates. I use an average interest rate (AIR) which is the average of the 3 Month T-bill, 5 Year T-Note and 30 Year T-Bond. Since 1970, whenever the AIR is below 5.0, the average P/E has been 29.
So without a great deal of imagination, one can put together a strong case for stocks being at least fairly valued at 1050. If you were brave enough, you could argue that stocks are even cheap when compared to returns on alternative investments. Of course, you can argue that the market is selling at 140 times earnings as well.
Personally, for the reasons above, my suggestion is to not rely to much on valuation as a timing tool and focus more on what the tape is telling you.
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