Three-Year High for the S&P 500’s P/E Ratio

On Friday, the Price/Earnings Ratio for the S&P 500 closed at a three-year high. By historical comparisons, the P/E Ratio still ain’t that high. It’s currently at 16.49. The ratio has been quite low for the last few years. At its low point in October 2011, the S&P 500’s P/E Ratio touched a 22-year low. All told, the market’s P/E Ratio was expanded by more than 40% which adds a nice breeze to any market rally.

Here’s a look at the S&P 500 (black line, left scale) along with its earnings (yellow line, right scale). I scaled the two lines at a ratio of 16-to-1 so whenever the lines cross, the P/E Ratio is exactly 16. As you can see, we just dipped our heads above the line. For technical note, I’m using the operating earnings as provided by S&P.

Let me point out a few deficiencies of the P/E Ratio. (By the way, just because there are some problems with a metric doesn’t make it useless. You simply need to be aware of its limitations.) The P/E Ratio is made up of two numbers, the price and the earnings. Price is a fixed-point number. You know exactly what it is at any point in time. Earnings, however, are a ratio. It’s the amount of money earnings between two points. The P/E Ratio mixes these two numbers. That usually isn’t an issue, but sometimes it can be.

The biggest problem is that stock prices look ahead while earnings tell you what just happened. Notice how in 2009 the stock market, the black line correctly anticipated the upturn in earnings, the yellow line. Because of the mismatch, the P/E Ratio soared. I remember this caused a lot of consternation among market bears. The P/E Ratio was telling us the market was expensive when it was really its cheapest.

Here’s a look at the market’s P/E Ratio. It’s the exact same graph as above except it’s the black line divided by the yellow line.

But we can also see something interesting about the market crackup in 2007 and 2008. What makes that period noteworthy is that it was largely unexpected as the stock prices quickly reacted to crumbling earnings. On the other hand, you can see how market downdrafts in 2011 and 2012 were incorrect expectations of trouble ahead. Perhaps the market was so burnt in 2008 that it’s become overly cautious today.

The issue for us right now is the stalling out of earnings growth over the last few quarters. The future part of the yellow line is Wall Street’s forecast. If analysts are correct that this is just a small notch in an upward earnings trend, the market is probably underpriced. At ratio of 16 and expected earnings of $123.13, it could be at 1,970 by the end of next year. That’s a 20.6% gain in about 20 months.

Of course, that involves a lot of assumptions that are probably too thin to rely on. Last year, I recall Barry Ritholtz pointing out a chart showing the success rate of analysts’ forecasts. It’s not an enviable record. To oversimplify things, corporate earnings tend to go in two modes — slow, steady rises or sharp dropoffs. Analysts try to split the difference by almost always predicting modest increases. As a result, they’re usually slightly too pessimistic or wildly overly optimistic. The hard part is catching the economy’s turning points. Once you’ve mastered that (LOLz), everything else is easy.

Posted by Eddy Elfenbein on May 13th, 2013 at 10:00 am

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