What Happened to Earnings and Valuation?

All eyes will likely be on the action across the Atlantic again today and likely the rest of the week, month, and perhaps quarter. Lest we forget, we have yet another purportedly “big meeting” with Team Merkozy today as the leaders of France and Germany are once again trying to figure out what to do about all the debt problems in the Eurozone and how to turn things around. However, I thought I’d take a timeout from the Eurozone death watch this morning and take a gander at something that used to matter to the stock market: earnings and valuation.

I know, I know, such an effort could turn out to be a complete waste of time – especially if rates continue to stay above the “unsustainable” levels in places like Italy and Spain. Oh, and before we squander too much of our valuable time on silly things like the fundamentals of the stock market, we should keep in mind that the default drum is starting to beat again in Greece and Hungary.

But I digress (shocking, right?). What I wanted to look at this morning was the issue of earnings on the S&P 500. I received a couple of notes last week questioning the validity of my statement that earnings were at record levels and thus, I thought I’d do some research to make sure I had not misspoken.

So, point number one on this fine Monday morning is that yes, the earnings on the S&P 500 for the trailing twelve months (using GAAP earnings) will be an all-time record high. According to Ned Davis Research, 12-month earnings are expected to come in at $89.87 for the S&P 500. This represents a 16.2% increase over 2010′s total of $77.35 and is a full $8.36 higher than the previous all-time high of $81.81 seen in 2006.

As of the end of 2011, this means that the GAAP P/E ratio for the S&P stands at 13.99. And in perusing a chart of the GAAP P/E ratios since 1926, a couple of things jumped out at me. First, is the fact that it looks like the current P/E is the lowest seen since 1991. Assuming my math is correct; this means that stocks are currently cheaper than at any time over the last 20 years.

The second thing that catches your eye when looking at a long-term chart of the S&P’s P/E ratios is that the current P/E is below the average for the entire period (85.8 years) and is WELL below the average seen over the last 25 and 50 years. The average P/E for the S&P 500 (again on a GAAP earnings basis) since 1926 has been 16.98. And over the last 50 years, the average P/E has been 19.25. As such, it would be hard to argue that the current reading of 13.99 is anything but undervalued to at least some degree.

Of course, the key thing to understand about P/E’s is that the concept of “fair value” is always a moving target. During good times, investors are willing to pay a higher multiple for $1 of earnings (think the late 1990′s). This is demonstrated by the fact that the average P/E on the S&P over the past 25 years has been an eye-popping 24.84. Conversely, investors are usually hesitant to “pay up” for that same $1 of earnings during more difficult times. For example, from 1960 to 1982, the high P/E was under 24 while the low was below 7 on two occasions. Thus, the average during the last secular bear probably was more like 12 or 13.

Broadening things out a bit, we can look at the P/E of the Value Line Composite. The current P/E stands at 14.4, which, based on data back to 1980, appears to be at the lower end of normal. And according to the computers at NDR, the S&P 500 has gained ground at a rate of 10.0% per year when the P/E on the value Line Composite has been between 12.9 and 16.4.

Finally, NDR estimates show that GAAP S&P earnings are expected to grow by 10% in 2012. And given that earnings increased by 16.2% in 2011 while the S&P went nowhere, it isn’t too hard to see that stocks just might have some upside if the sky ever stops falling across the pond.

Turning to this morning… Hungary actually completed a T-Bill sale but had to pay 7.77% for 6-week paper. The IMF is said to be losing confidence in Greece’s ability to reform anything. And “Team Merkozy” is meeting again in Berlin today. In response, European markets are close to breakeven and Wall Street is looking slightly higher.

On the Economic front… There are no reports scheduled for release before the bell today.

David Moenning
Editor:  The Daily Decision