S&P 500 PE Ratio Analysis for March 2010

by Hans Wagner, TradingOnlineMarkets.com | March 17, 2010

Each quarter, I review the expectations for the S&P 500 over the next two years. For this analysis, I use Standard & Poor’s earnings expectations for the S&P 500 as a reasonable place to begin. My goal is to determine a trading range for the S&P 500 for 2010 and 2011.

S&P 500 Earnings

With 99% of all S&P 500 companies reporting, the as reported earnings for the December 2009 quarter were $15.36 for the quarter and $51.15 for the year. From there Standard and Poor’s expects as reported earnings to grow to an annual rate of $72.20 by December 2011. Earnings staged a nice recovery from the depths of the recession, though they are still below the level achieved in 2005-2008. In addition, earnings ramp up during the remainder of 2010 and particularly in 2011.

The ramp up in earnings comes in at 21% increase for 2010 and 16% for 2011. Looking at the S&P 500 data over the past 50 years, year-over-year earnings growth has been greater than 20% only seven times and only twice after a year in which those earnings declined. With the huge drop in earnings in 2008 and 2009, the 21% growth in earnings for 2010 seems reasonable.

One of the issues we face when examining earnings is what is included and what is excluded. Many analysts use operating earnings, which excludes “one-time” charges. By focusing on operating earnings, analysts believe they are focusing on the ongoing performance of the company. The problem is these one-time charges usually stem from some part of the operating business that has encountered a problem. Nevertheless, the forecasts of S&P 500 earnings are usually for operating earnings, not the as reported number. Operating earnings will be higher than the as reported earnings. When considering forecasts of earnings for the S&P 500, be sure you understand what is included in the number.

Goldman Sachs has forecast earnings before provisions and write-downs for the S&P 500 of $76, 33% growth in 2010 and $90, 20% growth in 2011, using their top down approach. Their bottom up method generated an earnings forecast of $79 or 39% growth for 2010 and $95, 20% growth for 2011. This includes 85% growth from the energy sector, 83% from materials, and 183% from the financial group for 2010.

Bank of America’s forecast calls for $75 in operating earnings in 2010 for the S&P 500 and $85 in 2011. Bank of America forecasts earnings for the S&P 500 to reach $90 in 2012.

S&P 500 PE Ratio

The Price Earnings Ratio (PE Ratio) for the S&P 500 provides additional insight into the trends for the market. During economic expansion, the PE ratio tends to decline at a slow rate, falling from a high level. It turns out that a recession drives down the earnings faster than the market. When this happens, the PE ratio jumps up to account for the plunge in the market. In the chart below notice that the PE ratio rose significantly for each bear market, once in 1990-1992, then again in 2000- 2002 and again in 2008 – 2009.

The forecast for the PE ratio through the rest of 2010 and 2011 calls for the S&P 500 PE ratio to drop from 20 to below 16. This follows the pattern of previous recoveries from a bear market. Assuming we have a “normal” economic recovery with earnings rising as forecast, we should expect the PE ratio to decline as indicated in the chart above.

S&P 500 Index

For reference, the chart below shows the S&P 500 quarter end price from 1990 through 3/10/2010. For the S&P 500 to climb up to the 1,500 area with a PE ratio of 15 will require $100 in annual earnings. This is well beyond the forecast for earnings annual earnings of $72.20 to $90 for the end of 2011.

This raises the question what is the prognosis for the S&P 500 to move from its current 1,150 level. The table below shows a calculated S&P 500 using the annual as reported earnings forecast from Standard & Poor’s for a range of PE ratios from a low of 10 to a high of 30. Presently, we know that the PE ratio is about 20 based on the trailing annual as reported earnings through the end of 2009.

Assuming the PE ratio remains at 20 and the trailing earnings rise to $59.44 for the first quarter of 2010 from $51.15 delivered in 2009, the S&P 500 will reach 1,189, about 40 points higher.

As history has shown the PE ratio trends down slowly, falling to below 15 as the economy continues to improve and grow. Therefore, any expansion in the market, as measured by the S&P 500 comes from earnings expansion. If earnings grow as predicted and the PE ratio falls toward 15 by the end of 2011, the S&P 500 will remain at its current level. A PE ratio of 16 with annual earnings at the end of 2011 of $72.20 gives us an S&P 500 of 1,155.

The S&P 500 does not track exactly with earnings and the PE ratio. Rather it trades in a range around these expectations. If the PE ratio sustains a high of 20 throughout 2010 (an unlikely event) and as reported earnings remain as forecast, we could see the S&P 500 reach the 1,250 area. On the low side, we could see a PE ratio of 15 with the S&P 500 trading in the 900 area.

To place the PE ratio of 16 into perspective, the median PE ratio is 15.7. As a mean reverting measure, we should expect the PE ratio to fall to at least that level over time and go lower.

The Bottom Line

This examination of earnings and PE ratios is telling us to expect the S&P 500 to trade in a range with a high of 1,250 and a low of 900. What can change this prediction? First, earnings could rise faster than forecast. A more rapid rise in earnings will drive up the S&P 500 accordingly. For earnings to rise we need to see revenues climb faster. If Goldman Sachs is correct, the bulk of these revenues will come from the Energy, Materials, and Financial sectors. Consumer Discretionary will contribute as well. It will pay to monitor these sectors during the next few earnings seasons.

A recovery with a high unemployment rate will slow economic growth. Higher revenues are more likely to come from the higher growth regions such as Asia and parts of South America benefiting the Energy and Materials sectors. Prudent investors would count on these sectors to help their portfolio beat the market, since it looks like the S&P 500 will be range bound.

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/�

Contact Information

Hans Wagner | Colorado, USA | Email | Website