By Decision Point:
The following is fairly typical of a question I have received dozens of times over the last few years:
QUESTION: Hi Carl, I have been watching your chart showing the history of the actual S&P 500 versus the expected value based on the price to earnings ratio. It shows that the s&p 500 has never ever been so overvalued compared the normal P/E range of 10 to 20, and that earnings remain low. In 2003 the earnings started to increase before the S&P 500 started up. This makes me very wary of the run-up over the past 12 months, despite the hype on CNBC. What is your opinion on this?
ANSWER: We have to work with the most recently finalized earnings, which is Q3 2009. Because of this Q4 2008, which had a loss of -$23.25, is still used in the calculation of twelve months trailing (TMT) earnings. This distorts the P/E, currently 91. Q4 2009 will be finalized by the end of this month — 99% of S&P 500 companies have reported. At that point Q4 2008 will drop out of the equation, and earnings will be more normal again, giving us a P/E of about 22. Unfortunately, a P/E of 22 is still very overvalued and outside the normal range of 10 to 22. Here is a recent snapshot of earnings projections.
Here is the chart showing the historical P/E range. The recent earings crash looks scary, but the range display should return to normal in a few weeks.
I am concerned about the consistent overvalue condition that has been the norm since the early 1990s, but it has persisted through two bull markets and two bear markets, demonstrating that investors just don’t care about value. And the value range analysis we do, while an interesting curiosity, is not of much use for decision-making in the current environment. Follow the trend.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.