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P/E: Future on the Horizon

May 3, 2011

by Ed Easterling

EPS growth

Earnings growth is driven by economic growth. Both factors have their own cycle. The economy, as measured by gross domestic product ("GDP"), fluctuates every decade or so through expansions and recessions. Earnings growth, almost like a moon around a planet, fluctuates around the economy's course. Profit margins expand, bringing the responses of competition and production, only to be followed by excesses in both that contract margins to rebalance conditions. But balance rarely occurs. It remains an occasional crossing point for ever repeating cycles. That's why investors need tools to assess the overall trend, lest they be destined to zig and zag aimlessly without a compass to help them focus on the horizon.

Therefore, to estimate future stock market returns, investors need measures of earnings growth and market valuation levels (as measured by the price-to-earnings ratio, "P/E"). The Crestmont methodology for earnings per share ("EPS") and P/E provides a tool not only to evaluate historical trends and results, but also to assess the course of the market and its future on the horizon. Crestmont's EPS and P/E are based upon regressions and relationships between historical EPS and GDP. Thus, with future estimates of GDP, Crestmont's methodology provides forecasts of EPS.

[dshort note: for more details, see P/E: So Many Choices, Part I posted on April 26.]

For example, when the methodology was discussed in Unexpected Returns (written in 2004 and published in 2005), Figure 7.9 provided a prediction for EPS through 2011 (presented as Chart 1 below). It was based upon a forecast for GDP that extended then-recent history into the future.

Unexpected Returns

Note the upper-right graph; it provides an estimate for EPS from 2004 through 2011. It's ironic that we can now look back from the final year of a seven year old forecast to assess its credibility.

By 2006, the Wall Street pundits were laughing at the laggard line in Figure 7.9 as S&P 500 companies posted profits of more than $81 per share (compared to $56 on the chart). Their forecasts expected $100 per share within two years. It was as though the gravitational force of the business cycle had been conquered. The pundits led investors to see the Crestmont forecast as the old blue earth from outer space orbit, a remnant so far away that it was no longer relevant.

Two years later, the view for the trend line forecast had shifted — this time the pundits looked upward to see it (like the diver reaching for the water's surface). Chart 2 (below) presents the forecast chart from Unexpected Returns with an overlay of actual history through 2010 and the current forecast for 2011.

The pink line is the published forecast from 2004; the green line reflects what actually happened. It is very typical that the actual course of EPS, based upon many decades of history, zigs and zags around the natural course. Once again — today — the view is shifting and hope springs eternal on Wall Street. Reported EPS has surged past the base trend line ... and the current forecast by S&P calls for $99 in 2012. Maybe this time will be different (but I wouldn't bet on it!).

S&P500 EPS

Subsequent to 2004, the forecast for future Crestmont EPS downshifted slightly (as did the trend line for some of the recent years). The earlier forecast for EPS was based upon historically average GDP growth. But the economy in the 2000s fell short, even before the recession of 2008. As a result, the current outlook is a combination of continuing the slow-growth trend and restoring the historical average. That's why economic growth is Major Uncertainty #1 in Probable Outcomes.

Nonetheless, the range in Chart 3 fairly well frames the baseline course for the rest of this decade. The actual path, however, likely will stray wildly; but, the natural line that drives market valuation tracks within the channel.

Chart 3. Figure 12.1 from Probable Outcomes
Normalized S&P 500 EPS

The shaded triangle reflects the results under various assumptions. The upper boundary line represents the most optimistic assumption for nominal EPS growth. This includes 4% real economic growth and rising inflation. The lower boundary represents the least favorable assumptions: 2% real economic growth and deflation. The most likely result will occur within the field. Two points are included on the right side for 2009. The first relates to historical growth and average inflation; the second is average growth and low inflation.

Most importantly, the shaded "field" is where the earnings game will be played. It can serve as a compass for EPS to keep in perspective the normal business cycle as well as the over-extrapolated forecasts from manic analysts. For example, as of today, currently reported EPS and forecasts for the next two years exceed the top boundary. Profit margins are high. Within the next few years, the power of the business cycle will realign EPS growth back to its natural course. Don't be surprised, by the way, if reported EPS dips below the lower boundary — the magnitude of swings in EPS from the business cycle are dramatic. That is why a normalized measure for EPS, especially one that is forward looking, is so important to investors.