On March 7, 2009, I published an analysis S&P; 500 VALUATION ANALYSIS: NEAR BOTTOM in which I demonstrated that the “Rule of 20” is the most appropriate tool to value equity markets. I argued that this approach, which says that the sum of the S&P; 500 Index PE multiple and the inflation rate should fluctuate around 20, was in fact more appropriate than focusing on absolute PE ratios which take no account of inflation rates.
On March 16, I published S&P; 500 INDEX PE AT TROUGHS: A DETAILED 80 YEARS ANALYSIS to further document the case. I concluded that:
Using historical absolute PE lows to assess the potential downside to the S&P; 500 Index is simplistic and based on superficial, non-rigorous analysis. The absolute historical lows used by the bears, while strictly accurate, were attained in high inflation periods, not comparable to the present. Using the Rule of 20 to assess PE multiples takes into account the inflation environment and is thus a better tool to value equities in general. Using this method, and assuming inflation rates in the 0-2% range, trough PE multiples should be 12-14 times trailing earnings. The current financial crisis is substantially distorting S&P; 500 earnings, both reported and operating, in an unprecedented way. Using trailing earnings, reported and operating, can result in a meaningful underestimation of Index earnings in the present environment. Macro earnings estimates are more appropriate in the current exceptional circumstances. Goldman Sachs’ $63 estimate for 2009 appears conservative in light of historical evidence. A low probability worst case scenario would take earnings down to the $43 level. Trough valuation analysis shows trough S&P; 500 Index levels at 720 using 2009 estimates (which are lower than trailing), with a low probability downside risk to between 516 and 602.
The S&P; 500 Index troughed on March 9 at 666 and is up 37% since. Meanwhile, trailing operating earnings have continued to decline. They are currently around $43 and all indications are that they could trough around $41 by the end of the summer.
The combination of declining earnings in a surging market has brought the “Rule of 20” multiple from 16 to 21.1, slightly above its historical median of 20 (range of 15 to 25). As a result, the risk/reward ratio has moved from extremely positive (16/20) to somewhat negative (21/20).
Using earnings estimates as opposed to trailing earnings, one could justify buying equities at current levels, given that estimates for 2009 are about $60. On that basis, the S&P; 500 Index trades at a “Rule of 20” multiple of 15 (as is the absolute PE since the current inflation rate is about zero). Investors who have faith in such estimates and who expect inflation to remain near zero could keep buying stocks.
The case in favor of using estimates at present is supported by the fact that current trailing earnings include the exceptional Q4 2008 S&P; 500 Index EPS of $-0.09. So far in Q1 2009, earnings are already running at a $51 annualized rate.
Personally, I prefer using the comfort of trailing earnings, especially in an environment where major economic and credit issues remain largely unresolved and very challenging looking forward given the general need to deleverage. We must also not dismiss the risk of deflation which would negatively impact both earnings and PE multiples.
Let’s keep in mind that Mr. Market has merely reacted to “less bad” economic news. Green shoots may never become flowers. For now, investors increasingly expect blossoming from the number of green shoots spotted here and there. Yet, house prices keep declining, credit markets remain tight and consumer spending is weak. To be sure, an inventory cycle is about to erupt. But as long as final demand does not recover decisively, the bears may still have a shot at their sucker rally…even though the suckers are now 35% richer.