April 11, 2011 Analysis from Chris Turner
The first quarter earnings season gets underway today. In anticipation of revisions to future estimates, here is an update of Chris Turner's Thought Experiment published here in early April. The first chart below is based on the latest trailing twelve-month earnings (TTM) data published on the Standard &P Poor's website as of April 6th. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See my monthly valuation update for instructions on downloading the spreadsheet.
To get a instant read on the astonishing increase in earnings optimism over the past two months, here is the same chart based on earnings estimates in early February.
Here are the key assumptions in Chris Turner's latest calculations (first chart):
- 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 Q1 2011 through Q4 2011 are
83.97, 88.77, 94.01 and 96.26 (as of the April 6 spreadsheet).
The blue line represents Standard & Poor's TTM forecast earnings by month multiplied by the historical nominal 10-year P/E ratio. At 2011 year-end earnings of 96.26 and an average nominal P/E of 18.08, we would see the S&P 500 at 1740. At the this level, the nominal P/E10 would be approaching 32, and the index would be about 73% 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 18.08 and the 10-year average earnings of 50.41 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 above 1600 in the S&P 500 by early summer, 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.