Recent S&P 500 Rally Based On Earnings Expectations

Much of the recent rally in the stock market can be attributed to higher earnings expectations in the S&P 500 from an economy that is performing less badly than earlier. Does this justify the 29% rise in the S&P 500 over the last six weeks? Moreover, can this move up sustain itself and keep climbing, or at least find a plateau. Part of the answer to this question lies whether earnings expectations will be sufficient to support the current level of the S&P 500, let along a rising market?

S&P 500 Earnings Expectations

According to Standard & Poor’s in 2006, the S&P 500 delivered reported earnings of $83.11. This is before the current recession and collapse of earnings. That year the financial sector generated $43.93 or 45% of the earnings for the S&P 500. This includes the financial arms of industrial giants such as GE and GM. Most of these earnings have disappeared in the massive de-leveraging that is currently underway. In fact, Standard & Poor’s estimates the financial sector generated $37.77 in negative earnings in 2008.

The bursting of the housing and financial bubbles destroyed the basis for these profits in the banking sector. It is unlikely the earning in the financial sector will return to its former level before the market crash. Most of these excess profits were due to the idea that home values would continue to rise at unsustainable rates. The value placed on homes was significantly above the cost to replace the house, creating a flawed valuation. Once the valuation began to fall the debt used by many people to fund this growth and consumption became a millstone, bringing down everyone who participated in the bubble. The housing ATM that fueled higher prices in homes and excessive consumption closed. The economy is extracting its just payment for the over use of leverage.

Going forward the sustainable earnings of the S&P 500 will be less than it was in 2006. To expect earnings to return quickly to their former level is unrealistic. The de-leveraging process is far from over. The problems in the commercial real estate arena are just beginning. In addition, the housing industry will take years to return to its former level. First, there is the large inventory of unsold homes currently on the market, estimated to be close to 11 months at the current sales rate. Then there are the unknown numbers of homes that will come on the market from owners how have delayed selling during the current down market. This number is much larger than many think. Finally, without the excessive borrowing, the purchase of homes will be more restrained going forward. People will not be borrowing against their homes reducing the banks’ opportunity to lend.

It is reasonable to assume that the bulk of the financial sector earnings for the next two years will be either negative or near zero. This removes at least $40 from the 2006 level of S&P earnings expectations. Since the housing industry was a major component of the GDP for the U.S., its delayed recovery will also affect the expected earnings for the S&P 500. Some analysts estimate the housing industry will cost at least $5 in expected earnings of the S&P 500. Subtracting $45 ($40 + $5) from $83 gives us $38 for the expected earnings number for the S&P 500 in two years. Some might say that is the worse case. Fine, then add $12 to that number and we get $50 for the sustainable earnings for the S&P 500 for the next several years as the more likely case. By the way, Standard & Poor’s estimates that, as reported earnings for the S&P 500 in 2010 will be $39.59.

S&P 500 Valuation

The historical average for the S&P 500 PE multiple has been 14 - 16 times the trough earnings. 16 times $38 gives us 608 for the S&P 500. Using the Standard & Poor’s estimate of $39.59 for reported earnings produces an S&P 500 of 633 in 2010. Using the $50 in earnings gives us an S&P 500 value of 800. On April 17, 2009, the S&P 500 closed at 868.60.

In a slower growth environment, the typical trough PE ratio is more likely to be 8 to 10. Ten times $38 generates and S&P 500 of 380. Using the Standard & Poor’s earnings estimate of $30.59 gives us an S&P 500 of 396. Using $50 in earnings gives us an S&P 500 value of 500.

The point is the valuations of the S&P 500 are overly optimistic and based on an expectation that earnings for the S&P 500 will return to their former level rather quickly. This is an unrealistic consideration, given the current situation. Moreover, we could be facing the below normal earnings trends and below trend PE ratios.

The Bottom Line

Investors will do well to pay attention to the underlying fundamentals of the market. As earnings are reported, you should compare them to realistic expectations. Should there be any variance from what is expected, you should be prepared to make the necessary adjustments. A slow growth economy will require careful analysis of which are the best sectors to enjoy. It will also call for prudent stock selection, as a rise in the entire market will not carry the day.

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Comment by James

2009-05-11 22:02:05

Hey, good analysis. I saw the SP500 ER for 2010 is only $35.31 … where did you see that $39?

BU TD
2010 estimate $74.99 $35.31
2009 estimate 850.00 $55.74 $28.51

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