Forecasting the Market: A Thought Experiment Revisited

September 23, 2014

by Chris Turner

With nearly all Q2-14 reported earnings in the books, here is the latest update of my ongoing "thought experiment" for forecasting the S&P 500 price based on earnings fundamentals. The chart below is based on the latest trailing twelve-month earnings (TTM) data published on the Standard & Poor's website as of September 18th, 2014. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See dshort's monthly valuation update for instructions on downloading the spreadsheet.

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Here are the key assumptions in the calculations:

  • The 10-year average of nominal TTM earnings is 65.52 as of September 2013, rising to 77.70 by the end of 2015, based on "as reported" earnings forecasts.
  • The average nominal cyclical P/E10 is currently 18.25.
  • The S&P 500 historic prices used in the calculations are monthly averages of daily closes.
  • Standard & Poor's estimates of TTM earnings for Q4 2013 through Q4 2015 consist of the following:
  • The months between the quarterly earnings estimates are linear interpolations.

The blue line represents Standard & Poor's TTM forecast earnings by month multiplied by the historical nominal 10-year P/E ratio. At 2014 year-end earnings of $110.10 and an average nominal P/E of 18.25, we would see the S&P 500 at 2010. At this level, the nominal P/E10 would be 28.17, and the index would be about 54% above a hypothetical price multiple of the extrapolated 10-year earnings average (1310).

The red line represents a hypothetical S&P 500 price that is a multiple of the average nominal P/E10 of 18.25 and the 10-year average earnings of 66.85 for December 2013. The monthly index price estimates thereafter are linear extrapolations based on average 10-year earnings growth and earnings estimates from Standard & Poor’s.

The optimistic view (blue line) would put us around 1943 in the S&P 500 by the end of August, 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 the 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, Four Market Valuation Indicators and the compelling research of Ed Easterling on the history of earnings per share.

Check back next month for a new progress report.



Note from dshort: For some interesting comparisons, here are Chris's charts from the last several months, based on the then current Standard & Poor's spreadsheets.

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