S&P 500 Index: Soon To Be The Cheapest Since 1989

The recent swoon in the U.S. stock market has gotten to a point where there are plenty of values to be found for those investors willing to ignore the near-term headlines and negative sentiment. In fact, if things stay where they are for the next quarter or two, the S&P 500 index will be the cheapest it has been in more than 20 years (based on the current 2010 earnings estimate for the index of nearly $82). Below is a chart of the S&P 500’s trailing P/E ratio from December 31, 1988 through December 31, 2010 (the P/E for the next six months is an estimate based on current consensus profit expectation, assuming the market stays at today’s level).

Source: Standard and Poor’s Data

As of today we are at a P/E of about 14 (on this chart, the second to last notch on the x-axis). Assuming stock prices and earnings estimates remain where they are, the U.S. market would end 2010 at its cheapest level since 1989 (12.5 times trailing earnings). I know the headlines have been bleak over the last eight weeks or so, but stocks are quite cheap, especially given low interest rates and tame inflation.

If earnings season is pretty good this quarter (including in-line guidance for the second half of the year), as I expect it to be, I will very likely allocate some additional portfolio cash into the equity market. Although the market chatter is centered around the increased odds of a double-dip recession, it is important to note (as was pointed out on CNBC just this morning) that we have seen only 3 double-dip recessions over the last 150 years. Does that mean it is impossible we could get a fourth? Of course not, it just makes it probably a lot less likely than the U.S. equity market is currently indicating.

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8 Thoughts on “S&P 500 Index: Soon To Be The Cheapest Since 1989

  1. sagacious on July 2, 2010 at 2:17 PM said:

    Current earnings estimates are far too optimistic in my view, as they imply returns on equity well above the long-term average. A discounted flows of cash valuation for the S&P gets us to an intrinsic value 15% higher than today’s prices – a discount but certainly not a steal. Using Schiller’s historical earnings data (100 years), we’re at the 70th percentile of stock market valuations. Despite the recent sell-off and small discount, implied decade-ahead returns from today’s levels are still just about 7%.

  2. Chad Brand on July 2, 2010 at 2:45 PM said:

    I agree that 2011 earnings estimates are too optimistic (at around $95) hence I did not include them in this chart. But given we are already in July I do think we will finish 2010 at north of $80 for S&P 500 profits.

  3. bob goodwin on July 2, 2010 at 7:35 PM said:

    The gold standard for historical PE valuations is FATE (Schiller) those results show we are still above normal PE. Using future expected earnings is long since discredited as prematurely calling a bottom.

    Even FATE may be overestimating PE this time around, because there was a long term goosing of profits in the last decade from monetary policy and oversized financial sector. Future profits likely will be lower than those modeled by FATE, much less what you write.

  4. Paul Strohm on July 3, 2010 at 12:33 AM said:

    Hi Chad,

    The $82 estimate for S&P 500 earnings includes bank earnings, which, due to changes in FASB accounting rules, are extremely suspect.

    I don’t have the data in front of me, but I do know that the S&P 500 traded near 7 times ttm earning at points in the 1970s. Knock $10 off earnings to account for government sponsored accounting gimmicks for the banks and apply a P/E of 7 and you get a number around 500.

    I am not saying the index will go there, but there is room for plenty of downside. What of the falling M3? The economy is badly structured, what with annual capacity for 2 million homes and 18 million cars. I don’t see the necessary restructuring taking place. Instead the federal government and central bank are attempting to prop up the rotten edifice.

  5. James Altucher on July 3, 2010 at 9:33 AM said:

    Of course Chad is right. Schiller is looking at 10 years moving average.

    Why assume we go back to the 70s level of 7x? Interest rates and inflation were double digits. We’re at lowest inflation and lowest interest rates in 50 years.

    M3? There is no falling M3. The US govt no longer tracks M3 and the so-called “shadowstats” makes up their own estimate of it.

    “rotten edifice?” Quality of life has improved in America every decade since its inception which is why our economy is bigger than the next 4 combined.

    Take Chad’s number and now back out the cash on the books. Now we’re at a 10-12 P/E for S&P 500 depending on what estimate you use for 2010. The balance sheet of US corporate America is the best its ever been. Should XOM trade at 2x earnings next year? You can take that bet but I won’t (and Warren Buffett doesn’t).

  6. Steve Clements on July 4, 2010 at 1:53 PM said:

    Hi Chad: What is your response to those who say we should look at GAAP Earnings ($67 est. in 2010) versus Operating Earnings ($82 in est. 2010) ?
    Thanks for your article!

  7. Chad Brand on July 6, 2010 at 7:47 AM said:

    @Steve Clements:

    Many investors (including those who need to make bearish arguments for stocks to please their followers) mistakenly assume that GAAP earnings are preferable to operating earnings. After all, they are “generally accepted accounting principles” so they claim they are more accurate and less manipulative than the non-GAAP operating figures that companies and analysts use. Unfortunately, GAAP earnings are of little help to investors (who job it is to focus on cash flow).

    This is because equity shareholders own claims on future cash flow, not reported earnings. Operating earnings are actually much closer to actual cash flows than GAAP earnings because GAAP requires that all non-recurring and/or non-cash charges flow through the income statement, which reduces reported earnings (this is why GAAP numbers are almost always lower than operating numbers). Conversely, operating numbers typically focus on cash profits (with some exceptions… depreciation and amortization being the big one).

    Some of the more common bookkeeping entries included in GAAP earnings would be stock-based compensation costs, goodwill impairment charges, asset writedowns, unrealized gains and losses on investments, and one-time restructuring charges such as severance for laid off workers (this last one is a cash item but would not typically reduce one’s estimated value of a company).
    These are required to be booked as “losses” under GAAP even though the firm’s financial position is unaffected in all but the last example (because no cash changes hands).

    I recall that in late 2007 Sprint wrote down the value of its goodwill by $30 billion (from their il-advised acquisition of Nextel) and that single non-cash accounting line item dramatically impacted the GAAP earnings for the entire S&P 500 index! If you get a few of these in a single year, the numbers can vary a ton. Just looking back at 2008, S&P 500 operating earnings are $49 but GAAP earnings were $15. The same numbers were $57 and $51, respectively, for 2009. Based on that it is easier to see why people would think that 2009 earnings growth of 16% (57 vs 49) was more accurate figure than +240% (the GAAP figure — 51 vs 15).

    Hope that helps…

  8. Steve Clements on July 6, 2010 at 7:56 PM said:

    Chad, I sure appreciate your in depth response to my question on GAAP vs Operating Earnings. Thank you very much !

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