April 12, 2011
Last week guest contributor Chris Turner's article on S&P 500 Trailing Earnings offered a fascinating perspective on the relationship between price and earnings in the S&P 500 since the late 1980s. His research prompted me to create a series of charts documenting the relative growth of price and earnings from various starting points in market history to the present.
The chart below is an overlay of the real (inflation-adjusted) S&P Composite price and earnings since 1871. I've used a log-scale vertical axis and included exponential regressions to highlight the trends for both series. The yellow callouts show the annualized trend growth. I've also plotted a 10-year moving average of earnings for the benefit of readers who share my interest in the cyclical P/E ratio (real price divided by the ten-year average of real earnings).
If you click on the chart above, you'll see a larger version with links across the top to companion charts, each with a later start date: 1900, 1926, 1950, and 1982. The reason for multiple charts is to facilitate comparison of the change in the relative growth of price and earnings as we shorten the timeline. Why these five?
- The 1871 start date reflects the complete data series, which is available from Robert Shiller's Yale website and has become a mainstay of historical market research.
- The 1900 start is a round number popular with many chartists.
- The 1926 start matches the popular Ibbotson data cited by many investment firms in their promotional materials.
- 1950 is another of those round numbers, one that also has the distinction of starting near the beginning the post WW II economic boom.
- The 1982 start roughly coincides the beginning of the great Boomer Bull Market.
The table to the right shows the annualized growth of the regression trendlines through the price and earnings for each of the five overlapping time frames. I've tried to highlight the difference between the two for each time frame with the Price Growth Difference, the value that results from dividing price growth by earnings growth minus one.
Are We Approaching Peak Earnings?
The chart for 1982-present (see below) is slightly different from the other four. In this one I've also included Standard & Poor's TTM earnings estimates for 2011. We see that the estimates, even with an extrapolated inflation adjustment, take earnings to an all-time high. In nominal terms, the Q4 2011 TTM earnings estimate of $96.26 is a whopping 24.4% higher than the $77.35 equivalent for Q4 2010.
In short, 2011 earnings estimates are priced for perfection. Will first-quarter earnings start us off on the right foot? Perhaps. But shares of Alcoa (AA) dropped 4 percent at today's open after the company reported first-quarter sales that were below Wall Street's expectations. Will we look back on Alcoa's Q1 report as an outlier or a precedent for a recurring earnings-season pattern?
Let's conclude this look at earnings estimates with reprise Chris Turner's latest chart showing two extremes of market behavior based on forecasts of Price/Earnings multiples (more here). Over the four months since December 2010, the market has trended below the Price-Earnings multiple of earnings forecasts times the nominal average TTM P/E ratio. That pattern will probably continue in the months ahead. But there's a wide spread between the blue line and red line in the chart below, which leaves plenty of wiggle room between the extremes. Will the yellow boxes in future updates be closer to the blue line? Or the red?
We're a bit over 25% of the way through 2011. The eight-plus months ahead promise to be quite interesting.
Note: For readers unfamiliar with the S&P Composite index, see this article for some background information.