About three months ago, I wrote a piece called “How to Value the Stock Market.” The article addressed the relevance of price-to-earnings ratios (P/E) and earnings yields (E/P). On July 1, 2011, the S&P 500 Index stood at 1335, and estimated earnings were at 97.81. That left us with a P/E ratio of 11.95 and an earnings yield of 7.3 percent—both at levels that indicated the market was undervalued.
Here we are three months later, and the S&P 500 stands at 1140 with estimated earnings at 98.16. This gives us a P/E ratio of 11.61 and an earnings yield of 8.6 percent. At first glance, it looks as if not much has happened in the last three months, but it has. The recent figures reflect a 14.6 percent decline in the value of the S&P 500, a 35-cent increase in the total earnings of the S&P 500, and a 1.6 percent increase in the earnings yield.
To understand what these numbers tell us, let’s take a look at the historical averages. The P/E ratios of the S&P 500 from 1988 to today range from a high of 29.44 in the fourth quarter of 2001 to a low of 11.51 in the fourth quarter of 1988. Eliminate the extremes and you come away with averages that fall between 13x and 16x earnings. As of September 26, 2011, the S&P 500’s P/E ratio was 11.61, which puts us very close to the 1988 lows.
A 17-year look back at the earnings yield of the S&P 500 shows a range from our recent high of 8.6 percent on September 26, 2011, to a low of 3.4 percent in December of 2002. Simply put, this means that the expected earnings of the S&P 500 are 8.6 percent of the price of the index. This 8.6 percent is over four times the expected return of the ten-year Treasury. Why is this relevant? Because we are comparing the additional rate of return we expect to receive by investing in equities with the risk-free rate of return one can expect from investing in Treasuries. The last time the S&P 500 earnings yield approached 7 percent was at the end of 1994. The market responded with a five-year bull run from there.
In looking at these two indicators, one might think it’s time to back up the truck and load it with equities. Ahhh, if only it were that easy. There’s another side to this story, and it has everything to do with earnings. What I haven’t mentioned is that the level of downward earnings revisions in the past few weeks is near historic levels. Yes, the full year estimates for the S&P 500 are 35 cents higher (as of September 26) than they were on July 1, but they trail their highs of just over 100 on August 4. In fact, according to Bespoke Investment Group, over the past four weeks analysts have raised forecasts for 287 companies in the S&P 1500 and lowered forecasts for 717 others. That turns out to be nearly a 2.5-to-1 ratio. Add in the fact that so far during the earnings off-season (August 16 through October 10), 13 percent of the companies have lowered their earnings forecasts, while only 7.5 percent have raised guidance. That’s enough to keep a lot of investors on the sidelines.
This past earnings season turned out to be a very volatile time for the markets even though approximately 70 percent of the companies in the S&P 500 beat their earnings estimates. (Roughly 20 percent missed their number, and around 10 percent came in as expected.) What troubled the markets was everyone’s reluctance to project with any confidence what the next quarter or two might bring in the way of revenues and/or earnings.
As the third-quarter earnings season approaches, I expect markets to behave much as they did during the second quarter—which means lots of volatility. For those companies that beat their earnings estimates, there’s room for appreciation, and for those that don’t, there’s still room to decline further. What we all look for is the triple play: companies that outpace earnings estimates, beat revenues, and raise guidance.
If the estimates come in better than expected and the analysts have been too negative, there’s plenty of room on the upside. It may turn out that the P/E ratio as well as the earnings yield indicators have gotten it right. If not, maybe they’re just early.
I don’t think it’s time to turn a blind eye to the rest of our economic concerns, such as the ongoing problems in Europe, our own U.S. debt obligations, and the multitude of other issues we face. I wouldn’t exactly go on a buying spree, but I’d keep the truck in the garage and make sure it’s in running condition. I sure wouldn’t want to be left behind if my indicators turned out to be correct.
Timothy S. MicKey, CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall, on Twitter at @MonumentWealth and @TimothySMickey, and on their Facebook page. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for individuals. To determine which investment is appropriate, please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results.
Stock investing involves risk, including loss of principal. Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. Stocks are not guaranteed and have been more volatile than bonds.