Monday, January 5, 2009

Time to Buy Equities?

The Good

The Big Picture details performance of the S&P 500 in the five years following each of the 10 worst performing years for the S&P 500.

In each instance, the following 5 years brought varying, yet positive, annualized returns.

The Bad

John Mauldin's recent Newsletter '2008: Annus Horribilis, RIP' traces earnings estimates for calendar year 2008, revealing that estimates were far too optimistic ($92 in early 2007, down to a current $48 projection). Projections for 2009 are even lower, currently sitting at $42.

Putting those earnings estimates in the chart above, against the value of the S&P 500 Index at the time of each estimate, we can see how the price to earnings multiples "P/E's" have shifted / grown over time. The latest earning estimates puts the trailing P/E at ~19x, while the forward P/E ratio is even higher, at roughly 22x.

As John Mauldin points out:
That doesn't look like value at all, when the historical average is closer to 15.
The obvious question becomes, how low can earnings get and what is a proper level for the S&P given those levels?
In 2001, as-reported earnings were $24.67. Operating earnings in 2002 were $27.57. Does anyone think the current recession will be milder than the last one? Or shorter?

And it gets worse. Core earnings, which take into account pension and other under-reported liabilities, were less than $16 in 2001, and so P/E on a core earnings basis topped out at 71, and on an as-reported basis were as high as 46!
So lets be optimistic and say the current $42 earnings projected is the worst case scenario. Putting the historical 15x multiple average on those earnings (along with earnings, who knows where the multiple will be) gets us to 630 or a drop of another 33% (or about 15% less than November lows), while a multiple of 18x gets us to around 750, or a 20% drop.

While I actually expect the rebound to continue in the near term for technical reasons, fundamentals sure don't look attractive.

Update: Posted 'the Ugly' side of equities (i.e. P/E multiples) as requested.


  1. Jake - nice re-presentation of Mauldin's newsletter. Appreciate it. You should have gone ahead with "The Ugly" on future outlooks to complete the trifecta :) ! You might also want to re-visit Graham-Dodd's valuation formula where PE = (8.5+2*G)X 4.4/Y, where G=earnings growth and Y=AAA bond yield. If the economic outlook is for 2-2.5% growth on average over the next five years (IMF)at best and we presume a 5% yield a PE multiple of 10-12 becomes appropriate. Given that the markets were held up by leverage applied in one form or another (buybacks, housing ATM, consider a go-forward regime where a 15 historical average PE is inappropriately optimistic !

  2. i like the trifecta idea! i'll add that tonight

  3. awesome work Jake. I liked John M's piece but you have added well to that. and yea adding "ugly" would be even better. thanks again!