Is the S&P 500 Expensive?

I don’t know if anyone here follows the work of economists Nouriel Roubini, Robert Shiller, John Hussman or Gary Shilling, but in light of all the recent confusion over “the bottom”, I did some research into the types of earnings and multiples they use when looking at the S&P 500. By combining their methods, it seems as though there are essentially 3 types of earnings to consider when measuring “market climate” in bear markets. They include: Trailing Earnings, Peak Earnings and Normalized Earnings. The information below was taken directly from the S&P 500 data website (link):

  • Trailing EPS: $48
  • Peak EPS (2007): $84
  • Normalized EPS (5 Year): $65

Using data compiled by Shiller, let me point out the historic averages of each earnings multiple, as well as the levels they have often reached during cyclical bear movements in secular bear markets (often leading to the “bottoming process”). Note that I have adjusted them based on recent data:

  • Price to Trailing EPS: historic average of 16.5; bear market low levels of 12
  • Price to Peak EPS: historic average 13-14; bear market low levels of 7
  • Price to Normalized EPS: historic average of 15; bear market low levels of 10

Based on our different P/E types, and the levels they most often reach during bear market bottoms, we get the following:

  • Using Trailing EPS: $48 x 12 = 576
  • Using Peak EPS: $84 x 7 = 588
  • Using Normalized EPS: $65 x 10 = 650

I do not think any of these numbers in isolation can effectively predict the bottom. In fact, they are at best “intelligent guesses” because there is no assurance that past multiples will be witnessed in this bear market, especially seeing as interest rates are so low. The important thing to remember is that they provide a “probable range of outcomes”; we could see slightly lower earnings with higher multiples or vice versa (for instance, if 2009 earnings were to come in at $40 per share, and the multiple was slightly higher around 14 or 15). In any case, if history is any indication, the S&P could reach a low range between 576 and 650, which implies downside risk of 27 to 36% from the current level of 900. Bottom line: the market may still be relatively expensive.

The lack of consistency amongst analysts could be a result of “mixing and matching” different earnings with inapropriate multiples. I recently saw an analyst on CNBC claim that the market was cheap by using peak earnings with a bear market normalized earnings multiple. In doing this, she imputed $84 x 12, thus estimating S&P value at about 1000. This methodology seems flawed for 2 reasons: she used only 1 type of earnings, she used the wrong multiple.

I must say that if current market levels are slightly below “fair value”, I can’t imagine that buying carefully selected stocks would yield unsatisfactory long term results. That being said, buying stocks at significant discounts to intrinsic value when market levels are also at a significant discount seems like an ideal strategy. This is what Hussman calls “investing by valuation and market climate”. It doesn’t mean that we should try and buy stocks at 576 or below, but that we should try and focus on optimal ranges. I think Bernard Baruch said it best: “Don’t try to buy at the bottom and sell at the top. This cannot be done – except by liars.”

Note: All relevant charts can be found using the following links:


~ by eboro on December 19, 2008.

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