Last year, guest contributor Chris Turner made a case for using the 10-year average of nominal earnings in the cyclical P/E ratio made popular by Robert Shiller (Shiller uses an average of real earnings). See Alternatives to the Cyclically Adjusted Price-to-Earnings Ratio.
Today I’m featuring a “thought experiment” Chris shared with me in a recent email. He uses the trailing twelve-month earnings (TTM) data published on the Standard & Poor’s website. The latest 2011 forecast estimates are from the February 3rd 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 calculations:
- The 10-year average of nominal TTM earnings is 50.49 as of Q4 2010, rising to 55.35 by the end of 2011.
- The average nominal cyclical P/E10 is currently 18.06.
- The S&P 500 historic prices used in the calculations are monthly averages of daily closes.
- Standard & Poor’s estimates of TTM earnings for Q4 2010 through Q4 2011 are 76.86, 82.00, 84.73, 87.63 and 87.46 (as of February 3 spreadsheet).
The blue line represents Standard & Poor’s TTM forecast earnings by month multiplied by the historical 10-year P/E ratio. At 2011 year-end earnings of 87.46 and an average nominal P/E of 18.06, we would see the S&P 500 at 1580. At this level, the nominal P/E10 would be 28.8, and the index would be about 58% 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 18.06 and the 10-year average earnings of 50.49 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 the 1500 level in the S&P 500 by late spring, 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 Three Market Valuation Indicators.
We’ll revisit Chris’s chart periodically throughout the year.