Forecasting the Market: A Thought Experiment Revisited

We’re 99% of the way through the Q1 earnings season. Here is Chris Turner’s latest update on his ongoing “thought experiment” for forecasting the S&P 500 price based on earnings fundamentals. The first chart below is based on the latest trailing twelve-month earnings (TTM) data published on the Standard &P Poor’s website as of May 31. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See my monthly valuation update for instructions on downloading the spreadsheet.

Here are the key assumptions in Chris Turner’s latest calculations:

• The 10-year average of nominal TTM earnings is 50.41 at the end of 2010, rising to 53.94 by the end of the year.
• The average nominal cyclical P/E10 is currently 18.09.
• The S&P 500 historic prices used in the calculations are monthly averages of daily closes.
• Standard & Poor’s estimates of TTM earnings for Q2 2011 through Q2 2012 are
  85.57, 92.37, 95.66, 100.94, and 100.55 (as of the May 31 spreadsheet).
• The months between the quarterly earnings estimates are linear interpolations.

The blue line represents Standard & Poor’s TTM forecast earnings by month multiplied by the historical nominal 10-year P/E ratio. At 2011 year-end earnings of 94.80 and an average nominal P/E of 18.09, we would see the S&P 500 at 1730. At this level, the nominal P/E10 would be above 32, and the index would be about 77% above a hypothetical price multiple of the extrapolated 10-year earnings average.

The red line represents a hypothetical S&P 500 price that is a multiple of the average nominal P/E10 of 18.09 and the 10-year average earnings of 50.41 for December 2010. The monthly index price estimates thereafter are linear extrapolations based on average 10-year earnings growth.

The optimistic view (blue line) would put us at above 1700 in the S&P 500 by November, the assumptions being that the Standard & Poor’s earnings forecasts are correct the nominal P/E10 ratio is the multiple we see.

The pessimistic view (red line) is a reversion to the historic earnings and nominal P/E10 multiple.

But history shows us that, regardless of your preferred earnings divisor (nominal or real, TTM or 10-year average TTM), the P/E ratio has never hovered around the average. The market swings above and below its long-term average valuation in erratic arcs that can last for many years. For a long-term perspective on valuation extremes, see Four Market Valuation Indicators and the compelling research of Ed Easterling on the history of earnings per share.

We’ll revisit Chris’s chart periodically throughout the year.