Dshort.com published an interesting article recently that calculated what is known as the P/E10 of the S&P 500. The P/E10 is essentially the current real price of the index divided by the average earnings over the past 10 years. Benjamin Graham created this ratio to be a more robust measure of the market’s value, as during times of extreme market fluctuation the regular trailing P/E is prone to somewhat illogical results.
For example, the market currently shows a trailing P/E of 137.3, obviously due to the severely depressed earnings we’ve had this past year as well as to the recent run-up the market has seen in anticipation of future earnings. What is somewhat disconcerting is that the P/E10, while showing a more reasonable P/E of 19.1, still indicates the market to be overvalued in a historical context – the historical average P/E10 is about 16.3 while that of the trailing P/E is 15. This is even after the worst stock market decline in recent history; perhaps the stock market is getting ahead of itself?
Many of us will be watching for evidence of increased revenues this quarter, alongside hopefully increased earnings. Last quarter's earnings may have met already decreased expectations, but much of the earnings came about by way of cost cutting rather than top line growth. Since businesses likely had a stronger call to action for cost cutting than ever in our recent history, I would be surprised if the majority didn’t trim all that they could as quickly as they possibly could. Going into this earnings season there likely aren’t too many avenues left to cut costs. If the consumer isn’t the heavy-lifter this quarter that the market is expecting, and if revenues stay flat or decline as a result, then there isn’t much hope for even meeting expectations this time around. I wouldn’t be too eager to see the effect such a disappointment would have, especially after the strong run-up we’ve just had in the markets since March.
Every time in the past that the P/E10 went from the 1st to the 4th quintile (quintiles divide the P/E10 into 5 groups with the 1st being the highest P/E group and the 4th being the lowest P/E group) it’s ultimately declined to the 5th quintile where it bottomed in single digits. In March, the P/E10 of the S&P hit the 4th quintile after a long way down from the 1st and we are currently back into the 2nd quintile where the market is looking expensive. If a drop to the 5th quintile was to occur, it would come about from either a decline in the S&P to below 600 or alternatively from a strong resurgence in corporate earnings. If Q3 earnings didn’t have you waiting in anticipation before…
As an aside, in the past these declines have lasted anywhere from 3 to more than 19 years. The current decline is in its 9th year. I wonder how long earnings can remain weak for until the market decides to take fate into its own hands. In this environment I wouldn’t bet on it taking its time.
Jonathan Goldberg, MBA