Goldman: S&P 500 Now Undervalued

More from that excellent Goldman Sachs conference call yesterday… (See: “Good News: Stocks DO Recover After Financial Collapses“).  Goldman’s economists illustrate that US stocks are now below their long-term average P/E. This don’t help determine what they’ll do over the next year or two, unfortunately, but at least it’s nice to know you’re not getting rooked.

One quibble we have with this chart. It appears to use a single year’s earnings and therefore doesn’t account for the business cycle or the tendency for profit margins to regress to the mean. Profit margins are now dropping fast, but we still don’t think they are back to the long-term average (we haven’t seen a recent chart–please send along if you have one). High profit margins produce a misleadingly low P/E, and vice versa.

We therefore prefer to use “cyclically adjusted earnings,” which take average earnings over a 10-year period (see the second chart below). This smooths out the peaks and valleys of the business cycle and gives you a far steadier trend line. By this measure, fair value on the S&P 500 is about 900–another 7% or so below the current level. 

Of the two measures, “cyclically adjusted P/E” is more predictive of long-term performance.

Goldman (Straight P/E):

Andrew Smithers, London-based economist (Cyclically Adjusted P/E):

More on cyclically adjusted P/E and valuation here.

See Also:
Silver Lining: Stocks Finally Close to Fair Value

Good News: Stocks DO Recover After Financial Collapses

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