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Wednesday, February 21, 2024

Equities as a Matter of Belief

Courtesy of Doug Short.

Sure, Adam Smith coined the phrase “All money is a matter of belief.” Perhaps his description fits with equities as well. Lately, financial pundits tout the undervaluation of the S&P 500 “based on forward P/E.” Readers may benefit from understanding some simple math and seeing a pair of charts to assist in ascertaining relative valuations. Catch phrases like “generational buy opportunity” entice investors, but let’s consult the charts to evaluate those claims.

The first chart displays the differences between “Operating” earnings and “Actual” earnings to provide context for the earnings estimates favored by sell-side analysts. Operating earnings dismiss “one-time” charges (read tax code benefit) while actual earnings use Generally Accepted Accounting Principles (GAAP).



Both earnings correlated well up to the mid-1990’s, but then they began to diverge somewhat. While financial outlets use “operating” earnings almost exclusively, our 140 years of historical data use “actual” earnings due to the absence of historical operating earnings data prior to recent past.

The next chart helps determine “generational buy opportunities” relative to low Price-to-Earnings throughout history. Using common “cheap” P/E valuations of 7 to 10, the chart shows the S&P Composite in red and an “equivalent” S&P value calculated as earnings times the respective P/E level.



The math involved could not be simpler: historical earnings times the target P/E ratio. Where the actual S&P index intersects the calulated S&P highlights the times where “cheap” valuations were truly generational. Numerous studies present the likelihood of future returns based on current P/E’s; this visual display provides a quick snapshot of why these studies work. Based on this chart, about every 30 years investors have the opportunity to garner long-term investments. Also note that investors had periods of years in the “cheap P/E” category. An argument could be made that, without Fed intervention, the recent financial crisis would have provided investors with a similar generational opportunity.

How would the chart look if we use a smoothing process? The next chart displays our S&P 500 while showing an equivalent S&P 500 calculated by using an average of 10 years’ worth of earnings times the “cheap P/E.”



When using the smoothing process, the traditional single digit P/E calculations did not allow the equivalent S&P to cross the actual S&P (except in the very early 1920’s and mid 1930’s). But, by using higher multiples of 11 and 12, the smoothing process shows the same generational buy opportunities reflected in the previous chart.

These charts simply depict where the S&P 500 trades currently relative to historical precedence. The next time investors hear that the S&P 500 trades at low P/Es based on forward guidance, this chart will remind them how far the S&P currently resides from the generational buy opportunity. Investors still need to find yield, but this environment supports the use of “trading” strategies versus buy-and-hold “investing” strategies.





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