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Is the market Undervalued - A look at the S&P P/E Ratio

Recs

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July 05, 2010 – Comments (25)

There's been a sharp increase in bearish posts lately. And probably for good reason considering the economic numbers on unemployment, sovereign debt, and housing sales numbers. But I get tired of all this gloom and doom and like to sit back and look at the numbers. A 'reality check' so to speak.

Let's face it - it's corporate earnings that ultimately drive stock prices. While the P/E ratios may swing about anywhere from 10-30  depending on how bearish or bullish the market is - it ultimately swings back to some happy medium.  

Now for a look at the numbers. If you have never been on the S&P website - I advise you to check this link out http://www.standardandpoors.com/home/en/us  You need to register to get access to the data but it's free and well worth it. One spreadsheet I like to look at is the S&P500 EPS estimates. There's some nice historical data to look at here. Data is shown on a quarterly basis going back to 1988. Quarterly PE numbers on an "Operating" basis varies anywhere from 11.51 to 29.55. Doing a little statistical analysis the median PE since 1988 is about 18.23. 

Let's look at the estimates for the year as they stand today. 1st quarter is already in at $19.41. 2nd, 3rd and 4th quarters are $19.61, $20.70 and $22.01 respectively. Total estimated earnings for the year is $81.73.  This would be a 44% rise over 2009 earnings of $56.86. The numbers look even more attractive when you consider how conservative these estimates are. If you go back a few quarters and look at the estimates you will find that they are frequently low by as much as 50%.

Even if we assume the estimates are not low the PE ratio based on this number is a very low 12.61. This is close to the PE ratios we have seen only back in the late 80's. I believe this is too low a number considering how low interest rates are. Once we regain a little confidence in the market again I think we can return to more normal PE ratios in the future. 

What are my predictions? Given current conservative (and most likely low) earnings estimates of $81.73 and a worst case scenario depressed PE of about 15 we should still have a S&P year end around 1225.  If market sentiment improves and we get some positive economic news ----LOOK OUT!--- we could easily see S&P numbers as high as 1450 year end. Gotta love the market!

25 Comments – Post Your Own

#1) On July 05, 2010 at 4:18 PM, ETFsRule (99.94) wrote:

+1 rec

A lot of bargains out there... I think I'll load up on some BGC tomorrow

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#2) On July 05, 2010 at 5:10 PM, rofgile (99.30) wrote:

The earnings estimates are likely a bit high - the economic troubles in Europe should be reflected in lower sales for manufacturing corporations of the US (as Europe is typically the second biggest region for sales outside the domestic market for US manufacturers). The wind power industry worldwide is going to have earnings 60% !! lower than 2010.  Solar may also be lesser. The gulf states are having increased layoffs and lost revenue from tourism - so some local industries also will face headwinds.. 

-Rof

('However, I currently think we far undervalued again on too much pessimism.  I don't know how much deeper the market will overcorrect, but I'm in holding phase now.  If I had free cash I would be in buying phase!) 

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#3) On July 05, 2010 at 5:13 PM, JGus (28.72) wrote:

S&P EPS estimates can easily overstate actual earnings by a wide margin. Go back to 2006 through summer quarter of 2008 and look at what the estimates were for quarterly and yearly earnings through the rest of 2008 & 2009 . Let's just say that the estimates were far higher than what earnings actually were as the economic crisis unfolded.

The banking/finance industry has become an increasingly large share of S&P earnings over the last couple of decades. With consumers unwilling or unable to go deeper into debt, and the potential for significant financial reform (not the BS bill that is on the verge of being passed) it is hard for me to believe that bank earnings will return to their peak levels. This will lower S&P ear

Also, a PE ratio of 15 may seem 'normal' if you only look at the last 20-30 years of market history, but is quite high if you look back further in history.

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#4) On July 05, 2010 at 5:18 PM, JGus (28.72) wrote:

*This will lower S&P earnings going forward.

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#5) On July 05, 2010 at 5:32 PM, MoneyWorksforMe (< 20) wrote:

My prediction: Earnings overall will be okay, but much worse than last quarter. There will be quite a few misses with forecasts on par or lower than previously stated. The markets could have a temporary move upward (between 1% and 5% on the S&P) on earnings, but if there is I would sell into strength, as I believe in retrospect this will be viewed as a grizzly-size bear trap.

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#6) On July 05, 2010 at 5:50 PM, portefeuille (99.60) wrote:

bear trap

bull trap

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#7) On July 05, 2010 at 6:39 PM, dwot (67.78) wrote:

And what do you get for the average for the 22 years prior to your choice for comparison?

http://www.tradersnarrative.com/sp-500-price-earnings-ratio-long-term-chart-2330.html

I am with JGus.

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#8) On July 05, 2010 at 6:46 PM, MoneyWorksforMe (< 20) wrote:

I stand corrected. A foolish lapse in thought...Thanks.

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#9) On July 05, 2010 at 7:15 PM, ragedmaximus (< 20) wrote:

The market is in trouble. Jobs ,unemployment,Banks,World markets,BP oil spill.In my opinion the market is overpriced.The dollar,Euro and china yuan are all unstable along with production,energy,exports and growth.Sprinkle in unstable banks, healthcare and states going bankrupt what's left.If you've been paying attention lately CHINA and JAPAN citizens have been stockpiling physical GOLD at an alarming rate,part of the reason why GOLD continues to rise,why? probably because thier govts aren't afraid to tell thier citizens of what actually might happen a global stock market meltdown.Do you think usa govt would ever tell usa citizens,of COURSE NOT NEVER. so I suggest going short etfs buy gold or stay cash now and dont even try to anticipate a bottom or go long right now you will lose all over again.So the markets are OVERVALUED right now 

 

 

 

g

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#10) On July 05, 2010 at 8:36 PM, cthomas1017 (95.59) wrote:

I disagree with your conclusions (I'm in JGus' camp and will avoid being redundant)), but the concise & articulate way you stated your case was outstanding.  +1 Rec for your food for thought. :)

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#11) On July 05, 2010 at 8:56 PM, cbwang888 (25.86) wrote:

P/E doesn't tell the whole story. Overleveraged firms with excessive debts can go belly up quickly when the economy dips and money/credit supply becomes selective.

What is the S&P debt level comparing to pre-housing bubble days? How did companies like LEH, GM, AIG, C go down in a year or two or economy contraction if they have been mostly profitable for 50+ years?

 

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#12) On July 05, 2010 at 9:34 PM, goldminingXpert (29.46) wrote:

If we go up to 1450 this year, I'm giving up trading and taking up basket-weaving because every single thing I learned about economics and finance will be entirely wrong. Not that I'm betting either happens, but 666 is a helluva lot more likely than 1450 for year-end. Actually, if the market is over 1000 at year end, I'd be surprised. I'm looking for about 850 personally ... we'll have to see how quickly the recession returns and how the political upheaval plays out in November. If the Repubs manage to get the Senate back (quite unlikely), that could be quite bullish, though we'd probably have to have really bad news before that outcome could occur.

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#13) On July 05, 2010 at 9:40 PM, goldminingXpert (29.46) wrote:

P.S. your blog was actually pretty good, but by throwing in an absurd (minimum of +22% in 6 months and quite possibly +44% in 6 months, really?) shows how absurd your bias of the market is and thus discredits your post.

I, quite a bear myself, admit the S&P could finish the year as high as 1150 if everything went right for Obama, the Fed and the debt dominoes in Europe. My most-likely scenario sees us finishing the year around 850-900 (-10/15% from here) and I think there is an outside chance (3 in 100 or so) of revisiting the lows this year if everything goes to hell in a handbasket. I'm quite a bear, and yet I admit the market A) could go up, and B) I'm not calling AT MINIMUM for a 22% move.

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#14) On July 05, 2010 at 11:15 PM, kkotwani (99.67) wrote:

I dont conform to GoldMiningXpert's opinion nor I think market is extreme bargain.

In last two days....market has recovered drastically from lows.. even though market was net down....volatility coming down sharply...There is strong divergence between volatility and market price..This divergence has started building after sharp increase in volatility and sharp decrease in market.

This indicates strong sense of confusion between bears and contrarions (bullish) at this point.

Market is not very undervalued but somewhere less than fairly valued and more than undervalued. We can see 10 to 15 points more drop in S&P here where it will start feeling like great bargain. Given large number of people are net short at this point...any small good news will trigger huge gains in index as it will be defficult to cover short positions. Well thats how the classical contrarion theory works.

I am totally not convinced that we will see bad 2nd quarter earnings...More and more companies trying to run lean and mean...cutting costs/hiring and improving bottomlines....We will see the way we saw first quarter earnings most companies beating street estimates. 

Yes, there is no reason at this point that S&P will go above 1200 but also there is no reason that S&P will go below 1000. Its trading at the lowest of its fair range....I am buying bargains like hell here. I am betting mostly on basic material, energy, health and some bargains in other sectors.

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#15) On July 06, 2010 at 1:43 AM, goldminingXpert (29.46) wrote:

Technology, Consumer Discretionary and Financials are all WAY overvalued. The other S&P sectors are more reasonably priced, but those three I mentioned have at least 30% and probably 50% to drop from here.

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#16) On July 06, 2010 at 1:44 AM, goldminingXpert (29.46) wrote:

Actually, Materials (using XLB as my definition of materials) is also WAY overpriced. That's 4 out of the 9 or 10 S&P sectors.

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#17) On July 06, 2010 at 2:22 AM, Beorn10 (29.86) wrote:

I still have an overall bearish view of the domestic economy and the US markets, but I appreciate any bit of good news that may help keep bulls in the market.  I'm content to wait and watch as Asia and Europe still remain weak prior to the opening of the US markets this week.  Some opportunities will likely present themselves over the next few weeks, but an overall bet on the S&P 500 rising based on just a reasonable P/E ratio is more hope than I have left.

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#18) On July 06, 2010 at 7:14 AM, spellsly (71.30) wrote:

European debt won't be helped by an appreciating EUR, although it may assist investment. Good news for US debt if sale of the dollar becomes deeper monthly and Obama keeps on with financial reform. He is doing absolutely a first-rate job.

I would like to see more protection for the consumer against bank fee gouging. 

Equities will rise but if they dump train loads of treasury bonds in to the middle of it, people will begin leaving it to other people like the Madoffs of this world.. 

Housing has got to become affordable, at a time of high unemployment and non-existent job security and that is three separate questions.  

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#19) On July 06, 2010 at 7:44 AM, cthomas1017 (95.59) wrote:

"Obama is doing an absolutely first-rate job."

I can't even find words... 

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#20) On July 06, 2010 at 8:31 AM, rofgile (99.30) wrote:

cthomas1017:

 To do an absolutely fantastic job, he doesn't have to do much - just make less mistakes than the last guy.  I.e., as long as Obama doesn't start 2 wars, doesn't get us into a second recession, doesn't make backroom bargains with big oil (See Dick Cheney's Energy Task force - wouldn't it be nice to see those documents released to the public now!), doesn't short change science and education- then things are pretty good.

 Passing healthcare reform, increasing the NIH budget, focusing on Afghanistan - these are all pretty good moves from this President.

 And so far he's avoided government takeovers of the banks, the TARP worked, there are no death panels, he is an American citizen, and we are not on the path to socialism.  So, discounting the extremely nutzo fear mongering, he's pretty solid. Oh, and he hasn't raised your taxes!  Take that!

 -Rof 

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#21) On July 06, 2010 at 8:57 AM, Melaschasm (54.71) wrote:

Baring any major unexpected shocks, I expect the S&P to trade within a range from 900 to 1200 over the next twelve months or so.

The current correction/bear market could be indicating a double dip at the begining of 2011, or merely adjusting to slower economic growth. 

Considering that the S&P was only below 900 during the panic and fear months of the recession, I do not expect to revisit those lows, unless we have something unexpectedly bad occur.

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#22) On July 06, 2010 at 4:13 PM, FreeMortal (29.31) wrote:

The pessimism on these boards is fairly representative of the broader investment community.  For example, the Ned Davis sentiment index is well into negative territory.  As a contrarian indicator, this is normally a bullish signal.  But these times are not quite normal so I don't give it as much weight as I otherwise would.

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#23) On July 06, 2010 at 4:59 PM, rexlove (99.43) wrote:

rofgile - not sure why you think estimates are high now. They were low for the most recent quarter. This in spite of all the negative economic numbers that came out. Wind and solar? Are you kidding me - what are they like 0.1% of the S&P?

Jgus - valid points on the estimates but as I stated above estimates were low for the 1st quarter. These estimates came out after much of the bad news. Unless we double dip what potential news could drive estimates lower.

dwot - yes going back about 50 years the average is about 16.5. But this included a long period of higher inflation and interest rates. Still a 15 PE is below the 50 year average.

ragedmaximus - i never said the economic news wasnt bad. Just think you need to look at the numbers here.  

cbwang - not sure what news you've been listening to but most corporations are sitting on mountains of cash they dont know what to do with.

http://www.standardandpoors.com/products-services/articles/en/us/?assetID=1245215038552 

gmx - you're no stranger to outlandish predictions. Yours might be to the downside - mine happens to be to the upside.  ;)

 

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#24) On July 08, 2010 at 6:28 PM, dpdoor (29.04) wrote:

I did some math on what p/e you could buy a company and still make a profit. It comes out to 10 times earnings; takes about 7 years to break even 15 times earnings takes about 15 years. If the company grows then you can add the percentage of growth. 15 times earnings on a growing company is good. No growth is 10x.

In 1988 we were starting a major growth and it also was the year of the baby boomers coming of age to invest.

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#25) On July 09, 2010 at 1:02 AM, checklist34 (99.71) wrote:

just rec'd this post.

I don't think its too likely that year-forward earnings estimates are way conservative.  Its possible, but in general I think year-forward estimates tend to be slightly optimistic.

the bears point would be that...  if we double dip they will prove REALLY optimistic

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